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Everything You Need to Know About Construction Loans

Everything You Need to Know About Construction Loans

Unless you have mounds of cash lying around, you might not be able to pay for a construction project upfront. That's where construction loans come in handy! Here is your introductory crash course on construction loans…

Key Takeaways

  1. A construction loan is a short-term loan that finances the construction of a new building or home.
  2. Construction loan rates are typically higher than mortgage rates.
  3. The total loan amount is not given up front; the borrower will be given installments to pay for the current tasks at hand incrementally.
  4. Types of construction loans include Renovation, Owner-Builder, Construction-only, and Construction to Permanent.

Construction Loans… What Are They?

A construction loan refers to a short-term loan that provides funds to cover the cost of building or rehabilitating a home. Loans will cover expenses like the cost of land, drafting blueprints, permits, cost of labor, and materials. Future homeowners and commercial real estate owners borrow money from lenders to pay for the necessary materials and labor needed to construct a functional property. They can also use a loan to cover the cost of risk management fees.

How Do Construction Loans Work?

Before being approved for a loan, future owners will be thoroughly screened by lenders. During the lender screening process, the lender will likely want to see accurate budgets, construction timelines, and detailed plans for the project.  Some loans automatically transform into mortgage payments after construction, however, this is not always the case. Usually, mortgage rates are lower than construction loan rates because a construction loan is considered far riskier. If a construction project fails then the lender will have shelled out money with no collateral to make up for the loss. Alternatively, if someone fails to pay mortgage payments then the lender can seize the house as collateral. So, construction loans are far riskier overall.

When it comes to a construction loan, the total loan amount is not given upfront. Once the lender approves a loan, both the lender and borrower will agree on a withdrawal timeline. Based on the construction timeline, the borrower will be given installments to pay for the current tasks at hand incrementally. A schedule of values would help immensely with this.

What are the Different Types of Construction Loans?

Lenders offer different loans to suit the needs of the borrower and their project. It is important to review the different types of construction loans so that you can make the best decision for your project.

Renovation Loan

A renovation loan is exactly what you might guess… A loan for a renovation project! This sort of loan is most similar to a mortgage in the sense that it would cover the cost of buying a home and immediate renovations to said home. In this case, the loan rate would be evaluated based on the expected value of the home after renovations. These loans tend to be less risky since there is collateral in the case of a construction failure.

Owner-Builder Loan

In this sort of loan, the owner is also the builder. So, loan draws are made directly to the owner instead of a separate contractor. In order to attain this sort of loan, you must be a licensed contractor or someone who has demonstrated experience in construction or home building. Due to the complexity of new construction projects (attaining permits, compliance with building codes, contract and loan agreements, etc), the majority of lenders will not allow the owner to act as the builder.

Construction-to-Permanent

A lender will issue a short-term loan that covers the cost of land and building a home or other real estate project. The loan must be fully paid or refinanced into a mortgage after the construction is completed as there is only one closing to this type of loan.

Construction-Only Loan

A construction-only loan is quite self-explanatory. It is a type of loan that only covers the cost of construction. After the project is finished, either the loan is paid in full or the borrower will take out another loan or mortgage to pay it off. This is not the same as a construction-to-permanent loan because the loan does not automatically transform into a mortgage. Instead of one closing, this type of loan will involve two separate closings; one for the original loan and another for the subsequent loan. This sort of loan should be used only if the borrower is completely financially stable and confident that their financial situation will remain stable until the project is completed. If the borrower's financial situation is no longer stable, they might not be approved for a mortgage and won't be able to pay off the original loan.

Oftentimes, other types of loans will be confused with construction loans because of their similarities. Most commonly, end loans and land loans are falsely categorized as construction loans…

  • Land loans are for those looking to finance a purchase of a plot of land but are not looking to immediately build on the land.
  • End loans are a bit more involved; after getting a short-term construction loan, one might take out a long-term end loan to lay off the construction.

Getting a Construction Loan: Checklist

Getting a construction loan and starting your project is a large financial decision with some risk involved. To mitigate personal risk, review this checklist of everything you need to know and should do before applying for a construction loan…

  • Have a strong credit score- lenders will usually accept those with a very good credit score. Most commonly they require a minimum of 680. For risky or expensive loans they might require a minimum of 720.
  • Ability to Prove Income- lenders will want to ensure that borrowers have the financial ability to pay off these loans in full. Borrowers will need to provide proper documentation to prove their income status.
  • Low Lending Risk- Lenders will use assessments of lending risk when deciding whether to offer a loan. Mainly they will use LTC and LTV ratios.
    • The LTC (Loan-to-Cost) Ratio is most commonly used in commercial real estate and compares the loan amount to the construction cost. To calculate this value you will divide the total loan amount by the total construction cost. A high LTC indicates that the project is risky, and a lender might not accept you for a loan.
    • The LTV (Loan-To-Value) Ratio also assesses lending risk. It is calculated by dividing the total loan amount by the estimated market value of the completed project. The ratio will be used to calculate how much of a down payment a borrower should put down.
  • Ability to Offer a Sizeable Down Payment- lenders will expect owners to pay approximately 20% downpayment on the loan to ensure minimum collateral for the lender.
  • Find a reputable lender- When searching for a lender, ensure that the lender is experienced and trusted. The lender's offers should robustly fit the needs of your project. Here are some things to consider when searching for a lender…
    • Fair rates and fees
    • Timely approval and closing
    • Responsive customer service
  • A Schedule of Values- A schedule of values outlines all costs involved with a construction project. The document will allow you to organize all expenses and will ensure that your LTC and LTV values are accurate.

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