Construction Financing 101

When trying to determine how to finance the construction of a new store, facility, or commercial space, the short-term loan option designed to satisfy these financing needs is defined as construction financing. A lender in the construction financing space disburses loan payments in installments referred to as “draws”.

Unlike conventional loans, draws are upfront-milestone-payments, paid upon the completion of specific phases of construction such as laying foundations, putting up drywall, framing, plumbing, wiring, and so forth. Draws are approved once the lender inspects the construction and appraises the progress of construction.

Before applying for financing, it is important to understand the various types, pros and cons of construction financing.

Types of Construction Financing

Construction financing includes the disbursement of funds for items such as land, licenses, permits, fees, labor charges, material costs, closing costs, contingency bills and interest payments.

Loans offered through construction financing are calculated based on the potential value of a future property. Rates and terms of building-financing depend on the selected loan of choice. There are five major types of construction loans worth considering for borrowers seeking construction financing.

Construction-Only

Known as standalone construction loans, construction-only financing is paid in entirety only after the project is complete. This prevents the borrower from stressing about the principal amount at the time of construction. The only requirement for the borrower is to pay the interest on the principal amount during construction.

Construction-To-Mortgage

Also referred to as construction-to-permanent loans, this financing type requires a down payment of 20% and upwards apart from interest payments. Borrowers pay variable interest rates during the construction and switch to a mortgage upon completion of the building project.

Construction-Renovation Financing

With construction-renovation loans, financing is managed directly by the property owner and not the bank. Once the project is complete, the total cost of the construction will be added to the permanent mortgage.

Builder-Owner Construction Loan

When the builder and property owner is the same person, construction-only financing saves money. Lenders approve builder-owner construction loans to parties that produce proof of a developer-trade license.

End Loan or Mortgage

Once the building construction is complete, refinancing the loan costs can be completed by using a new construction loan termed an end loan or mortgage. It is a long-term financing option to repay short-term construction loan costs.

Main Things To Take Into Consideration

Construction loans are modified for building and repairs. However, before applying, explore the benefits and drawbacks of building-financing to avoid costly blunders over the long-run.

Pros

• Borrowers do not pay the principal amount at the time of construction, but the interest of the disbursed draw amount.
• Unlike traditional loans, construction loan rates and terms are fairly flexible.  
• As the lender separately reviews the construction process, the extra scrutiny adds to better and faster building operations.
• Construction loans gives the freedom to customize any infrastructure according to owner preferences instead of settling for pre-built structures.

Cons

• Given there are no collateral assets involved in construction financing, the interest rates will be higher in order to mitigate lender’s risks.
• Dealing with building documentation can be a hassle when applying for construction loans.

Conclusion

Construction loans are especially helpful financing tools for managing building costs if cash flows are erratic. To heighten the likelihood of obtaining favorable terms, a good credit score is a strong determinant. Moreover, ensure that the debt percentage is less than 45% in the debt-to-income ratio to receive quicker approval for construction loan requests.

Ultimately, in order to find the right construction loan, it is best to assess lenders’ eligibility criteria and compare all the available options before applying to ensure the best possible outcome.