A construction loan is a short-term loan used for the construction of a new home or building, making it an ideal short-term financing option for a residential or commercial real estate construction project. These loans can also be used to finance major renovation projects for long-term homeowners. The application process for these loans is generally very stringent: applicants are asked to provide detailed information about themselves, their construction project, and the costs expected to be associated with each aspect of the construction process. Furthermore, applicants are often expected to have high credit scores and to put down large down payments.
How Do Construction Loans Work?
Depending on the type of construction loan a contractor receives, they will need to pay different interest rates on different schedules. For example, a term loan allows loan recipients to be given a lump sum for which they pay interest and then pay back the loan within a set term based on the length of the project; in contrast, many construction mortgage loans involve funds being distributed to the contractor in a series of multiple payments on which the contractor pays interest. Some contractors may opt for a construction to permanent loan, which converts to a standard mortgage when the construction process is over. The type of loan a contractor wants will depend on the specific details of their construction project.
Interest Rates
Although construction loans often have higher interest rates than typical mortgages, contractors usually pay less interest in total because of the short-term nature (i.e., less than one year in length) of these mortgage-like loans. The interest rates of construction mortgage loans vary by lender but can range from up to 5-10%. In contrast, the interest rates of construction to permanent loans (in which interest is only paid on the loan’s outstanding balance) are tied to the prime rate and can fluctuate over time. However, one benefit is that some non-lump-sum loans essentially act as lines of credit and only require interest to be paid on the amounts actually used by the contractor in a given stage of their construction project.
Fees
The main fee that can come into play with a construction loan is associated with closing costs. If a construction loan is closed separately from a permanent mortgage loan, contractors or homeowners may need to pay more fees related to two closing costs. Otherwise, the only fees that must be paid are the monthly payments required to pay off the construction loan.
Down Payment
Most construction loans require a large down payment of 20-25% of the project’s total cost. This requirement ensures that you are committed to the project and are dedicated to its success. If cash flow is an issue, but you own the land on which the construction is being completed, some lenders will allow you to count the land’s value toward your down payment.
What Are the Main Reasons to Get a Commercial Construction Loan?
Commercial loans can be used to cover the main costs associated with construction projects. Some of these costs include the following:
- Purchasing Equipment and Materials: If you’re building a new home or facility, you can use commercial financing to buy the materials and equipment you need to complete the construction project. These can include lumber, trucks, and more.
- Expanding a Company’s Facility: Small business owners can use a construction loan to expand their current facility or build a new one. These loans are designed for shorter-term construction schedules, making them a potentially more straightforward option than applying for SBA loans or other commercial loans.
- Hiring and Training Employees: If you’re running a construction project, you can use a construction loan to hire new workers. You can also put the money from your construction loan toward training these new employees to ensure that they’ll do their best work on the job.
- Overcoming Damage or Disaster Expenses: It can be hard to see a disaster coming. Suppose your commercial building or office is damaged or destroyed by an earthquake, tornado, or other unforeseen disasters. In that case, you can use the money from a construction loan to repair your facility.
What Are The Benefits Of Commercial Construction Loans for Your Business?
There are several benefits to taking out a construction loan. The first is the short-term nature of the loan. Because most construction loans generally operate on a timescale of a year, they make it difficult for contractors to accrue a ton of interest while still allowing them to pay their staff and suppliers.
Additionally, the stringent application process is ideal for builders who need to finalize their plans. Because most lenders won’t sign off on a construction loan to a contractor without carefully examining their construction plan and schedule, it can help inspire contractors to design and stick to an organized, efficient plan.
Finally, many construction to permanent loans offer contractors flexibility in terms of their ability to pay back their construction loans. Because these loans convert to mortgage-like loans after construction is complete, small business owners have the opportunity to pay back their loans on a longer timescale — which can be beneficial if their cash flow is relatively limited. While construction loans may not be ideal for every contractor, their short-term and flexible natures make them perfect tools for many builders embarking on new construction projects.
