Construction loans are financing specifically designed to fund the building or renovating of homes or commercial properties. They provide the necessary funds during the construction phase, allowing borrowers to focus on their projects without worrying about a lack of funds. Whether a seasoned builder or a first-time home buyer, this guide will give you a comprehensive overview of the construction loan industry, from the application process to the types of loans available.
Understanding the Basics
Construction loans are short-term financing solutions that provide funding for building or renovating homes or commercial properties. Funds are typically disbursed in stages, corresponding with different phases of the construction process. The loan is paid off once the construction is complete, either through the sale of the property or with permanent financing.
They are different from traditional financing in several ways. For example, the interest rates are typically higher, and the repayment terms are shorter. Borrowers must also provide regular updates on the construction’s progress and comprehensive information about their project, including plans, specifications, and a construction budget. Below we will look at the several types of loans and terms you may uncover throughout your journey.
Private Lenders for Construction Loans
Private construction loans are an alternative financing option for borrowers seeking financing. Unlike traditional banks and financial institutions, private lenders can offer more flexible loan terms and a greater willingness to work with borrowers who may not meet the strict criteria of conventional lenders.
Private lenders can offer a range of funding to meet the specific needs of borrowers. These can include the following:
Hard money loans are short-term products designed for real estate investments, including construction projects. They are secured by the property’s value. They can fund a property’s acquisition, renovation, or new construction. This financing is generally more expensive than traditional loans. Still, they offer a faster approval process and more flexible lending criteria. They are typically funded by private investors and are secured by the property that is being built. In addition, they can be a valuable option for real estate investors who need funding quickly, have poor credit, or need help with financing through other channels.
Bridge loans are short-term as well and provide interim financing until a permanent loan can be obtained. This type of financing is typically used to fund the construction or renovation of a property while the borrower is waiting for longer-term financing to become available. Bridge funds are often used by developers and investors who need to move quickly to secure a property or complete a project.
Mezzanine loans are financing that sit between equity and debt. They are typically used to fund the construction or renovation of a property when the borrower needs more equity to secure traditional financing. Mezzanine financing is often more expensive than other types of funding. Still, they can be helpful for borrowers who need additional funding to complete a project.
Single Close Construction Loans (also known as one-time close or construction-to-permanent). These financing options allow borrowers to finance the construction and permanent financing into one loan, eliminating the need to separate them. The financing provides funding for the construction process and then converts into a traditional mortgage once the project is complete. In addition, they offer several benefits for builders, including streamlined processes and simplified documentation requirements.
With a one-time close construction financing, the borrower applies for the loan before construction begins. The lender disburses funds in a series of draws throughout the construction process. This allows builders to access the funds they need to cover the costs of labor and materials throughout the project. Once construction is complete, the loan is automatically converted into a traditional mortgage without additional applications or underwriting.
This type of funding involves two separate loans for the construction phase and one for permanent financing.
This funding option is for individuals wanting to act as contractors and build homes.
Jumbo Construction Loans
Jumbo loans are a type of mortgage loan used to finance the construction of high-value residential properties. They are typically used to build large, luxury homes that exceed the maximum limits set by government-sponsored mortgage programs. For example, suppose you’re in the market to produce a high-end residential property. In that case, jumbo construction financing may be the financing solution you need.
One of the benefits of this type of financing is that it can be tailored to your unique financial situation. For example, they often have flexible terms and conditions, allowing customization to meet your specific needs. This can include setting the loan term to match the expected completion date of the construction project or designing a repayment schedule that aligns with your expected income stream.
As you may have guessed, jumbo construction loans offer higher borrowing limits than other mortgages. Furthermore, they can also cover many construction-related expenses. These include construction costs, building materials, land acquisition, permits and fees, and architectural and engineering services. This can help streamline construction and cover all expenses under a single financing arrangement.
Like any mortgage, some challenges are associated with these types. For example, jumbo loans often have more stringent requirements than traditional mortgages, including higher credit scores and lower debt-to-income ratios. They may also require a larger down payment, typically around 20% of the total project cost. Therefore, it’s essential to carefully consider the terms and requirements before deciding whether it’s the right financing option for your needs.
A real estate investor purchased a large distressed property to move in with his family; however, most of his capital was tied up in other investments. He contacted The Tier Group to help find the funding needed to remake this dream location in Columbus, Ohio. After discussing his needs, we determined a jumbo construction financing option would suit him best. The loan, initially $1.5 million, has skyrocketed his property’s value by an additional $2 million.
Interim Construction Loans
Interim construction loans are short-term financing solutions builders use to fund construction projects. They are typically used to cover the cost of building materials, labor, and other expenses associated with the construction process. They are paid back in full once the project is completed and the property is sold or refinanced. Interim financing gives builders greater flexibility and control over their projects. With this type of financing, builders can customize their loan terms to meet the specific needs of the individual project, including things like interest-only payments, lower down payment requirements, and flexible repayment schedules. This can make it easier for builders to manage their cash flow, completing projects on time and within budget.
Another benefit of these financing options is that they allow builders to lock in their interest rates early in construction. This can be particularly valuable in a rising interest rate environment, where interest rates will likely increase over time. Locking in their interest rates early on, builders can save money on interest payments and potentially increase their profits on the project.
One potential drawback of interim construction loans is that they can be more expensive than traditional financing solutions. They are typically short-term and involve higher risk for the lender. As a result, the interest rates on this funding may be higher than those of traditional financing. However, this is often outweighed by the benefits of the loan, including the ability to start and complete construction projects quickly and efficiently.
A former client put a newer company servicing the California area with us. He needed help scaling his business because he could only take on a limited number of projects simultaneously. As a result, our network of lenders was able to assist him using the interim loan. In addition, the business could purchase additional equipment that had previously limited its work scope. As a result, his company has grown faster in the last 9 months than in the previous 4 years.
Ground Up Construction Loans
Ground-up construction loans provide funding for the entire construction process from the ground up. This loan is used to construct new buildings, including commercial and residential properties. Ground-up financing is similar to other construction funding in providing financing for the construction process. However, they differ in their eligibility requirements and how the funds are disbursed. Like different types of loans, Ground-up includes funding for the entire construction process, including the purchase of land, construction costs, and other expenses associated with the project. The funds are typically disbursed in a series of draws as the construction progresses to cover labor and materials costs. As with other financing options, interest is charged on the disbursed funds, and borrowers must make monthly payments during construction.
The eligibility requirements for these are similar to those for other construction funding. Lenders typically require that borrowers have a solid credit history, a sufficient down payment, and a detailed plan for the construction project. In addition, lenders may require borrowers to provide detailed financial projections to demonstrate the project’s feasibility. The disbursement schedule is one significant difference between this and other construction funding. In this type of loan, the lender disburses funds in a series of draws based on the completion of specific stages of the construction process. This ensures that the funds are used for their intended purpose and that the project remains on schedule and within budget.
Non-Recourse Construction Loans
Non-recourse construction loans are a type of financing that is used to fund new projects. Unlike other types of financing, non-recourse financing limits the lender’s ability to collect more than the collateral value of the project if the borrower defaults on the loan. In other words, if more than the value of the project is needed to repay the debt in full, the lender cannot pursue the borrower’s other assets or income to make up the difference.
This financing is better for many borrowers because it protects against personal liability. This is particularly important for developers taking on large, high-risk projects with more significant potential for failure, like hotels, by limiting the lender’s ability to pursue personal assets in the event of default. They can protect borrowers’ personal wealth and limit their financial exposure. Because they limit the lender’s ability to collect on the loan, they may require a higher down payment or a more robust credit profile. However, in exchange for these requirements, borrowers may be able to negotiate more favorable interest rates, longer repayment terms, and more flexible repayment schedules.
Non-recourse loans are also better for borrowers seeking to minimize risk. By limiting their personal liability and ensuring that the project is the primary source of repayment, borrowers can reduce their financial risk and make more informed decisions about their projects. This can help to prevent over-leveraging and other financial risks that can lead to defaults and financial distress.
USDA loans for new construction
One of the questions we often ask is whether the USDA does construction loans? The answer is Yes! USDA Construction loans are financing backed by the United States Department of Agriculture. They are designed to help rural homeowners, and home buyers build or purchase a new home in a rural area. This financing is provided by approved lenders, such as banks and credit unions, participating in the USDA’s loan program. In addition, these lenders can offer a range of products, including construction-to-permanent, which can be a useful financing option for borrowers building a new home in a rural area.
The construction-to-permanent funding process typically involves two stages. The first stage is the construction phase, where the borrower uses the funds to build the home. During this phase, the borrower will typically make interest-only payments on the loan.
USDA Construction to Permanent Loans
Once the construction is complete, the loan will convert to a permanent loan. The borrower will begin making regular principal and interest payments. The interest rate and terms will be based on the borrower’s creditworthiness and other factors. To be eligible for USDA construction funding, borrowers must meet specific criteria, including having a credit score of 640 or higher, meeting income and debt-to-income ratio requirements, and purchasing a property in a designated rural area.
One benefit of USDA construction funds is that they offer low or no down payment options. This can be particularly helpful for borrowers with small cash for a down payment. Additionally, the USDA often has competitive interest rates and flexible credit requirements.
Who Offers USDA Loans
USDA construction loans can be a helpful financing option. By working with an approved USDA lender, borrowers can access various loan products, including construction-to-permanent, to help them achieve their homeownership goals. Several banks and popular lenders offer USDA construction financing, including:
- Wells Fargo
- U.S. Bank
- TD Bank
- Flagstar Bank
- Capital Farm Credit
- Bank of America
- Farmers Home Administration
- Commerce Bank
It’s important to note that while these banks and financial institutions offer them, not all may offer them in all areas. Additionally, the eligibility requirements and terms may vary by lender. Therefore, it’s essential to research and compares various lenders’ offerings to find the best loan for your needs.
Learning More about the Application Process
The application process for financing involves several steps, including:
- Submitting application: To apply for a construction loan, you must submit an application that provides information about your construction project, income and assets, and other relevant financial information.
- Review of plans and specifications: The lender will review your goals and specifications for the construction project and assess the project’s feasibility.
- Approval: Once approved, the funds will be disbursed in stages, with regular inspections by the lender to monitor the project’s progress.
What to Consider When Choosing a Lender
When choosing a lender, it’s essential to consider the following factors:
- Interest rates: Compare interest rates from different lenders to find the best option for your construction project.
- Repayment terms: Consider the repayment terms offered by other lenders and choose the one that best suits your needs.
- Fees: Look for lenders with transparent prices, and compare the fees charged to find the best option for your construction project.
- Experience: Consider the lender’s experience in construction loans and choose a lender with a good reputation in the industry.
What You Can Expect Construction Loan Process
During the loan process, you can expect the following:
- Higher interest rates: They typically have higher rates than traditional financing.
- Shorter repayment terms: They have shorter repayment terms, typically 6 to 18 months.
- Staged disbursement of funds: The funds will be disbursed in stages, corresponding with the different phases of the construction process.
- Regular inspections: The lender will conduct regular checks to monitor the construction project’s progress.