What Is Construction Finance?

Also known as a self-build loan, construction finance or loan refers to a short-term loan taken out to finance the building of a home or real estate project. This construction loan is taken out by a homebuyer or a builder to finance a building project costs even after long term funding has been obtained.

These construction loans have higher interest rates than mortgage loans.

Construction finance loans are often taken out by builders or homebuyers who have chosen to custom build their projects. They are short term loans that usually run or a period of one year after the building is completed, the borrower can refinance the construction loan into a permanent loan or take out an end loan to cover the construction loan.

As the construction remains ongoing, the borrower may be required to pay off the loan’s interest on some construction finance loans while others may require the total balance to be paid off at the project’s completion.

These construction finance loans are paid directly to the constructor rather than the borrower. Payment may be made in installments (draws) as the project reaches new stages. Before each draw, the bank inspects the project to verify the estimated cost as well as how far the construction process has gone. Construction loans may be taken out to build new homes and also to restore old projects.

Types Of Construction Loans

If you are considering applying for construction loans, there are several options you can consider depending on your project type. These include:

• Construction-to-permanent loan: these loans are best for timeline projects. The bank pays the builder as the work goes on, and at the end; the cost is converted to mortgage at closing.
• Construction-only-loans: once the building is completed, these loans are expected to be paid in full. They can, however, be converted to mortgage at the end of the project; however, you would have to search for a lender yourself and get the loan to be approved the second time.
• Renovation construction loans: these loans are best to cover renovation projects

How Construction Finance Affects Your Company

As a business owner, construction finance loans can both positively and negatively impact your business. Before taking out these loans, you need to understand just how far these loans can make or break your business in the long run.

Positive Impacts Of Construction Finance On Your Business

There are distinct benefits with taking out construction loans over other lines of credits and loans. These benefits have tremendous impact on your business, and they include;

• Limited Interest

Unlike other forms of credits, construction loans have limited interest, which accumulates and are payable while the construction is still ongoing. As the principal down payment is not to be made until the project is completed, you would only be expected to pay lower interest-only payments on the loan.

Other credit options available however charge interest and the capital at the same time until the loan has been completely paid off. However, construction loan interests end once the project ends. As such, you are given enough time to save up to finally complete the total loan repayment at the end of the project. Construction loans cost friendly for businesses looking to develop building projects.

• Flexible Terms

While you would need to provide the bank with plans and other details around your project, construction loans are even more flexible than traditional loans. The loan terms and guidelines are more manageable for construction loans, which allow you to work the loan around your project needs.

The payment terms are also flexible as a down payment for the principal is not expected to be received until the project completion, meaning that you can begin to acquire income off the property to make your loan repayment.

• Scrutiny Allows For Structure

Often, there are stories of construction workers slowing down or stopping the construction process due to mismanagement of funds. When construction loans are given out, they are paid installments (draws), before each draw payment is made, the bank sends its representatives to inspect the project and ensure that the project is, in fact, ongoing and the estimated cost is correct.

While at first, this added scrutiny may seem like a burden; in reality, it keeps the project ongoing as workers are kept on their toes. This way, you are guaranteed that your project remains within the planned budget and stays on schedule; you do not have to spend more money or more time.

Negative Impacts of Construction Loan

Construction loans are very flexible; however, they are much harder to qualify for. For a business to be eligible for this loan, such a business has to have high credits and down payments. A credit score of about 680 and a down payment of 20% are typically required before any business can be granted these loans. However, when they are eventually gotten, they could also have negative impacts on your business. These include:

• Short Term Loans

These construction loans are short term loans which range between a period of 6 months to 2 years. Within this period, you can afford to make only interest payments; however, if your project would take a more extended period to complete, then your business profits might be affected by the interest payments.

You also need to be able to pay the loan in full once the project is completed, as such you might need to take out alternative financing loans to pay off this loan, acquiring new debts for your business in the process.

• Higher Interest Rates

The interest rates of construction loans are variable, but they correspond to a certain percentage over the prime rate or rate given by a bank. That is, if the prime rate is 6% and your loan rate is prime rate plus 2%, then you would be paying 8% interest.

The interest rates for construction loans are, therefore, higher than those charged on conventional bank loans. This is due to several reasons including the risk investment, borrower profile as well as the property condition.

When taking on a new construction project or undertaking a renovation on a real estate investment, construction loans are particularly useful. However, before taking on these loans, you need to have an understanding of the impact these loans would have on your business.