What Are The 2 Types Of Construction Loans?

Funding construction can be a challenge, and most people find they need some assistance. Construction loans are short term loans you can use to build your own real estate. Typically, these will be offered for a set term, during which the property will be built – this is usually a year. You may need an end loan once the construction has been completed, which is a new loan that effectively pays off your initial construction loan.

The two construction loan options

Bridging finance

This is a short-term loan to bridge a gap when it comes to funding. Funders of bridging loans typically don’t require a property portfolio. But they still require a properly-packed proposal. They will generally provide construction finance of around 65% of the property’s value. The loan periods vary from one month to three years, and, depending on circumstances and the nature of your project, you can have access to the funding within a few weeks.

Joint venture

If you join forces with a more experienced developer, you are more likely to be able to secure funding and have a successful project. This can be provided for 24 months, and you have the benefit of the know-how of someone who has done a similar project before. Financiers will provide between £150,000 and £2,000,000, up to 50% of the gross development value (or what the project will be worth once completed), pay all the building costs or a contribution towards the purchase price.

How do construction loans work?

When the construction loan has been approved, the lender starts to pay out the money as per the loan agreement. Rather than one up-front payment, this is done at intervals called draws.

Throughout the duration of the build, there are usually several draws. As an example, they may pay 10% when the loan closes to the builder, the next 10% when the foundation is set, the next portion of funds when the house is framed and the other amount when the house has been sealed up.

The number of draws and payments included in each are agreed by the bank, builder and the buyer. Standard protocol is that the first draw is funded by the buyer’s down payment – that way the risk is with the buyer and not the lender. The bank might also organise an inspection before each draw to ensure everything is on track and will then pay out the draw.

What are lenders looking for in a construction loan application?

First things first – some experience. You need to show you understand the costs and that you’ll be able to maintain control throughout the project. Developers lacking experience usually underestimate the costs involved when planning. Proposals can be complex if you’ve not put one together before, so a lot of lenders won’t even consider direct applications.

The main reason for this is the risk involved for your bank. They are being asked to lend money based on an uncertain property value on completion. This makes lenders nervous. There are more factors that can affect this, such as if property values dip or the work carried out is not of a good standard, and in these cases, the bank will have made a bad investment as the loan then exceeds the value of the property.

Are there any downsides to construction loans?

  • The property may not be completed on time or within the allotted budget. If the work takes longer than anticipated, a fee might need to be paid to extend the loan.
  • The construction costs might exceed the value of the finished building. This could be because the market fails or because the builder is not up to scratch. If this happens, you would need to find extra capital to refinance the construction loan into an end loan.
  • Non-eligibility. If your income or credit changes during the time of the project, you might have your end loan application declined. Construction loans are not supposed to be permanent so this could create a problem. If you aren’t able to pay the balance by refinancing and the lender refuses a loan extension, they could assume ownership of the building.

What is a building loan?

Building loans are short term loans that you can utilize to fund the construction costs of a building project. Many different types of builds are covered and building loans can be known by various names, including homeowner loans, house-building loans, construction loans, and home building loans.

They differ from traditional mortgages, which are based on similar sales and the property’s value. When it comes to a building loan, the agreed loan amount depends on the total cost of the build. Mortgages are given as a one-off lump sum, but a building loan is typically paid in ‘draws’, or pre-agreed installments.

These are usually shorter in terms of your typical home loans and can involve higher interest rates. It’s not unusual to have a year-long contract to allow for the property to be built.

How much do building loans cost?

This varies depending on the finances of the company or individual, such as their existing debt and credit history. The amount loaned will also determine the interest rate and the payment schedule. Construction and building loans are meant to cover the cost of the build, so how much you borrow really depends on the size of the project. You’ll be asked for a lot of information about your intentions with the project, so make sure you are honest and realistic.

Where other circumstances prevent building, construction loans make it possible, but you need to ensure interest rates are considered. If you’d like to draw on your construction loan, you’ll likely be paying a variable rate, which can go up or down. In addition, a lot of construction loans are interest-only, meaning you’ll be paying interest on the total borrowed amount as opposed to the loan balance.

When it comes to new construction, you’ll probably need to put down a large down payment. There’s more risk with a construction loan than a home loan, so interest rates will usually be higher. The type of loan will determine the cost as well – as an example, a building loan works differently to a small business loan even if they are both for construction. The deposit you need to put down is usually around 20% or 25%.

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