A construction loan is short term loan secured to finance the construction of real estate. Construction loans have a varying tenure (often around one year), after which the borrower is expected to pay back the loan. The interest rates on a construction loan vary with the borrower and the state of the real estate industry.
However, the rates are much higher than those seen in permanent mortgage and other related real estate loans. Construction loans are very powerful tools that can be used to complete a building project. However, they are also very risky and should be approached with caution. This post highlights what you need to know about construction loans, including how to qualify for one and what your alternatives might be.
How Does A Construction Loan Work?
As mentioned earlier, construction loans are short term loans, and their basic function is to help you commence and complete your building project. Once the project is finished, individuals often take out a permanent loan, also known as an end loan which is used to pay off the short-term loan construction loan.
The end loan has a lower interest rate than a construction loan, and that’s why individuals opt to use them to refinance the construction loan. They can help you save money based upon the differences in interest rates between the two.
What Are The Requirements?
Besides the higher interest rates, construction loans are also harder to secure. They have stringent qualification requirements because they are mostly unsecured. With a mortgage, you can use a house as collateral and get one fairly easily. The process is straightforward because the lending institution can seize the house if you’re unable to pay back. However, with construction loans, this is not an option, so the lenders compensate with more strict conditions.
To be eligible for construction finance, you need:
A Great Credit Score
Your credit score is how lenders determine your credibility. The credit score is calculated using a combination of several financial statistics, including your payment history, your current debt status, the types of credit facilities you’ve used in the past, your new line of credit, as well as the duration of your debts. The better your credit score, the higher your chances of securing a construction loan, and vice versa.
A Sizeable Down Payment
Most lenders require a down payment of 20%. Some even go as high as 25%, and the reason is simple; if you can provide a down payment, it means that you are capable of carrying out the cost of construction, even if the project takes an unexpected turn.
A Stable Income
Having stable income ties in closely with being able to make the 20-25% down payment on the loan. If you have an income, it simply supports the idea that you can continue the project, even if the project goes above budget or takes a longer time.
A Reputable Builder
Lending institutions will require you to prove that you have a reputable and licensed builder working on your project when you apply for a construction loan. Considering your builder’s experience and reputation, there are higher chances that the project will be concluded on time and within budget. You’ll need to include a list of the builder’s past and current projects, as well as profit and loss reports in your application as this can further assure your lender that the project will be completed as planned.
The Plans And Details Of The Project
Your lender will require detailed information of everything involved in your project, from the size of the lot and the size of the house to the materials you intend to use, and how long the project will take. If you have a reputable builder on your team, this process will be much easier for you to complete.
Appraisal Of The Property
While it’s difficult to appraise a property that hasn’t been built, you will have to provide your lender with details on how much it will be worth once completed. The overall value of the property will depend on the location, as well as the current market conditions.
What Are The Types Of Construction Loans?
Earlier, we discussed how end loans are taken to pay off construction loans. Sometimes, these two loans are taken as a single loan, and in that situation, it’s called a construction-to-permanent loan. The construction loan is simply converted to a permanent mortgage once the project is completed. Because the loan is basically a two-in-one agreement, you’ll only have to pay one set of closing costs, which can save you some money.
A construction only loan is a scenario in which you take out two separate loans—one at the beginning of the project, and one after the project is completed. A construction-only loan has its advantages. For example, you’ll be allowed to make a smaller down payment than if you had taken a combination loan. The risk associated with a construction-only loan is that you may not be able to qualify for a mortgage once the building is completed. If for any reason, your financial situation changes, you may find it difficult to pay off the high-interest construction loan.
What Are The Alternatives To Getting A Construction Loan?
Even though construction loans are a great way to finance your building project, they have their drawbacks. They are often difficult to secure, as they have strict requirements. Additionally, they have high-interest rates and require a substantial downpayment. Because of this, individuals often seek out other ways to finance their building projects. Here are some of the alternatives to construction loans that you can explore:
- Finance the building project yourself. You can finance the project by yourself if you have enough capital. That will allow you to circumvent the high-interest rates, and you’ll also retain more of the building’s returns in the long run.
- Get a bridge loan. A bridge loan is a loan that’s taken out with an expectation of a future payment. If you’ve sold one of your homes but are currently waiting for the escrow to expire, you can take out a bridge loan.
It is very important that you evaluate your business to see if a construction loan is best for you. If the project is big enough, construction loans are great way to share some of the risks. Depending on your agreement with your loan providers, if the project goes sideways, you can minimize your losses. Make sure to consult with financial experts before taking a decision.