Construction loans, also known as “self-build loans,” are short-term loans used to finance the construction of your home or another real estate project.
In this article, we’ll define construction loans, explain how they work, tackle special considerations, examples, and pros and cons.
Let’s dive in.
Defining Construction Loans
Commercial real estate investors and/or businesses take out construction loans to finance the construction of a home or another real estate project.
Construction loans are short-term loans.
They’re used to cover your project costs before you obtain long-term funding. Additionally, most lenders consider construction loans to be relatively risky, so they come with higher interest rates than typical mortgage loans.
How Construction Loans work
Construction loans usually last for a period of 1 year, and they’re structured on a drawdown basis. As opposed to receiving your funds in a lump sum, you’ll draw down your funds based on a specific schedule. Draws might be based on specific phases of your project or on a certain percentage of the project completed. For example, you might have a draw for:
- Framing out the property
- Installing the drywall, windows, and doors
- Installing HVAC systems, electricity, and plumbing
- Final completion of your commercial property
Once your project finishes, you can either refinance your construction loan into a permanent mortgage or obtain a new loan to pay off your construction loan. These new loans are sometimes referred to as “end loans.”
Different types of Construction Loans
One-time Close Loans
Two-time Close Loans
Commercial Construction Loans
Multifamily Construction Loans
Hard Money Construction Loans
Also known as a construction-to-permanent loan, these loans automatically convert into a long-term mortgage once your property is finished.
You only apply for and close this loan once, and you’ll only need to pay closing costs once.
Two-time close loans divide into two loans: one loan for the construction phase and one loan for the mortgage phase after your property is completed. You’ll use the second loan to pay off your initial construction loan.
Two-time close loans let you shop around for the best rate and terms for each loan.
However, you’ll also need to go through the application and closing process twice, each with its own closing costs.
Additionally, you won’t lock in your mortgage rate until your property nears completion.
If you’re confident your financial situation will remain the same during a lengthy construction process, then two-time close loans might be a great option.
Owner-builder loans let you act as your own general contractor.
Although owner-builder loans give you significantly more input and control over the process, it costs significantly more time. Owner builder loans can be created as one-time close loans.
Commercial construction loans are used to finance a multi-family home, apartment building, high-rise, office center, or other large commercial projects.
Most commercial construction lenders are risk-averse. That means they’ll expect developers to shoulder the majority of the risk associated with the loan, and they’ll require borrowers to present cash on hand to finance the project.
To secure a commercial construction loan, make sure you have strong personal credit, the ability to make a large down payment, financial documents, and a builder with a good reputation.
Multifamily construction loans are a specific type of construction loan used by real estate developers to finance multifamily properties. Read all about multifamily construction loans here.
Hard money construction loans are a great option for developers who need funds, but who may not present a good fit for traditional lenders. Additionally, if your construction project has specific deadlines, then a hard money loan can help you avoid waiting for a conventional or government loan.
Hard money loans are provided by hard money lenders, investors, or investment groups. These loans aren’t subject to traditional banking requirements, which means lenders have more flexibility with respect to loan terms.
Most hard money loans are secured by the real estate you’re purchasing; because hard money loans come with greater flexibility, you’ll often see higher interest rates than the rates you’d get from a bank. Additionally, hard money loan lenders require you to invest your own capital into the construction project.
Who offers construction loans?
Construction loans are typically offered by local credit unions and/or regional banks.
Local banks tend to be more familiar with the local housing market, and they’ll be more comfortable underwriting construction loans to borrowers in the community.
What are the interest rates for construction loans?
Because construction loans pose a higher risk for the lender, you’ll pay higher interest rates.
Construction projects typically take a long time, so you might wonder if your interest rate will change over the course of your project.
Some lenders offer a long-term rate lock option, others don’t.
Interest rates for construction loans typically fall around 4.5%, which is about 1% higher than a normal mortgage loan for the same time period.
Pros of construction loans
Construction loans can be a great option to finance the construction of your home. Some of the benefits of construction loans include:
Your lender will require you to provide specific plans for your construction project; however, construction loans are generally more flexible in terms and guidelines as compared to traditional loans.
This added flexibility often allows you to secure loan terms tailored to the needs of your individual project.
Longer payment timeline
Construction loans don’t require you to pay back the principal of the loan until your project finishes.
That means while you’re constructing your home, you’ll only be responsible for paying interest on your loan.
You’ll have more time to save and you’ll have a lower monthly obligation to your lender.
Option to transition to a traditional loan
Many construction loans allow you to easily transition to a traditional loan after the completion of your project.
This option lets you access the money you need to finish your project along with sufficient time to repay the funds.
Detailed analysis of your plans
Any lender offering a construction loan will take a close look at your project.
Additionally, an independent party will examine your plan.
You’ll need to draft and submit clear timelines and goals for your project, along with the details of your construction plan.
It’s important that you work with an experienced general contractor who can provide you with details about methods, workers, materials, timelines, etc.
Cons of construction loans
Construction loans come with tons of benefits, but they’re not without some downsides.
Hard to qualify
Qualifying for a construction loan isn’t easy. Because construction loans are seen as risky, lenders often impose higher credit score requirements and down payments.
Most construction loans come with variable interest rates. Lenders will charge you the prime interest rate plus a spread.
When you’re constructing a house, you often change your plans or you encounter unexpected costs. Any modifications in your building plan have the potential to increase your costs.
Special considerations for your construction loan
Before you commit to a construction loan, it’s important to remember a few special considerations.
First, most lenders require a minimum 20% down payment for construction loans. Some might even require up to a 25% down payment.
Because construction loans are riskier than regular mortgage loans.
As a borrower, you might face difficulty securing a construction loan under those terms, especially if your credit history is limited.
Additionally, if your home is not yet built, you might encounter a shortage of collateral that will prevent getting approval from a lender.
To get approval for a construction loan, you’ll also need to provide the lender with a “blue book”—a complete list of construction details—and you’ll need to prove that a qualified builder will be involved in the project.
Example of a construction loan
Say you decide to build your new house for a total of $800,000.
You go to your local bank and secure a one-year construction loan for that amount, and you agree on a drawdown schedule for that loan.
During the first month, you need $80,000 to cover expenses, so you draw down that amount from your loan
Fortunately, you’ll only pay interest on that amount, which saves you money.
As your construction project continues, you draw down on funds in line with your drawdown schedule.
You pay interest only on the funds you draw down, not on the entire term of the loan.
Qualifying for a construction loan
Construction loans come with a complicated approval process because lenders consider them risky.
When you’re applying for a construction loan, lenders will typically consider these common factors:
Your credit score matters, just like it does for a traditional mortgage.
For most conventional and USDA construction loans, you’ll need at least a 620 credit score. VA construction loans don’t specify a minimum requirement, but 620 is generally a good benchmark.
Down payments on construction loans are generally comparable to traditional mortgages.
For example, FHA construction loans require a minimum down payment of 3.5% for HUD-approved projects, and 10% for non-HUD-approved projects.
USDA construction loans have a minimum downpayment of 10%, and conventional construction loans typically require 5% or more down payment.
VA construction loans don’t require a down payment.
Details and specifications
Lenders will want to know the exact details of your construction project.
You’ll need to provide blueprints of the house along with specifications.
Work with your architect or general contractor to ensure that your plans comply with the rules and regulations in your area.
Finally, you’ll need a home appraiser to review those specifications and determine the value of your loan.
Contractor and lender review
Lenders will closely evaluate the general contractor that you hire to build your home.
It’s crucial that you choose an experienced, knowledgeable general contractor.
Additionally, your general contractor will help present the budget and cash flow necessary for your project.
Lenders will typically review the contract between you and your contractor.
Commercial real estate investors and/or businesses use construction loans to finance the construction of a home or another real estate project.
Construction loans are short term loans. That means they cover your project costs before you obtain long-term funding.
Construction loans are structured on a drawdown basis. That means you’ll draw down funds based on your specific schedule, not in one large lump sum.
When you’re applying for a construction loan, make sure you remember the following factors.
- Credit score and income minimums
You’ll need a great credit score to get approved for a construction loan. Make sure your debt is paid off, and get your debt-to-income ratio as low as possible. Most lenders want to see a credit score of 680; some only approve loans for borrowers with a score of 720 or better.
Most lenders take income into account when evaluating your loan application. A low debt-to-income ratio is a must.
- Down payment
Typical down payments for construction loans hover around 20% of the project’s total cost.
- Present a detailed plan
Lenders will want to see a detailed plan for your construction project. Take the time to work with your contractor to build out a detailed, quality plan to present to your lender.
- Select a builder
Make sure you select a vetted builder who is both licensed and insured.
Construction loans usually last for a period of 1 year. They’re structured on a drawdown basis.
When you are approved for a construction loan, you won’t receive your funds via one lump sum. Instead, you’ll “draw down” your funds based on a specific schedule set by you and your lender. Draws might be based on specific phases of your project or on a certain percentage of the project completed.
Construction projects are always expensive, and construction loans can be a great way to secure the financing for your next project.
That said, construction loans come with their downsides. They’re not the best option for everyone.
At Loanbase, we make it easy to figure out the best financing options for you.
Instantly connect with a list of commercial lenders in order to find the best loan that fits your unique needs.
You’ll also get access to our experienced capital advisors, all of whom have decades of experience in sourcing, vetting, and qualifying lender-borrower relationships.