How to Get a Construction Loan for Business

Various difficulties are specific to running a building or contracting company. The length of time it takes to finish a project might double if bad weather strikes, demand tends to rise and fall with the seasons, and in most cases, expenses are incurred before the job is paid for. Finding and keeping good employees is challenging because of the high turnover rate. Keeping track of money when a construction business goes through unanticipated ups and downs can be stressful. However, knowing you have access to the funds you need is essential as you develop a business strategy. Learn how contractors and building firms can benefit from a construction loan.

What is a construction loan?

A construction loan is a form of short-term finance specifically designed to fund the outlays necessary to construct a home from the foundation up. The acquisition of property, the preparation of blueprints, the acquisition of permissions, and the payment of labor and materials could all be covered by a construction loan. If the project cost ends up being higher than expected, you can use the extra money from your construction loan to cover the difference. Also, you can use the money as a reserve if you’d rather not pay interest while the building is being put together. There are a few similarities between construction loans and regular mortgages, but there are also significant distinctions. The land itself is the only collateral for construction loans, whereas the value of the building itself and the loan’s principal serve as collateral for mortgages. Moreover, the money from the construction loan is distributed in stages, called “draws,” rather than all at once. Repayment terms on a construction loan are typically much shorter than those on a mortgage loan, sometimes as little as six months (usually 15 to 30 years). Although both interest and principal are included in monthly mortgage loans, construction loans typically require only interest payments during the repayment period.

How does a construction loan work?

Borrowing funds in the form of a construction loan enables would-be homeowners to finance the acquisition of building supplies and the payment of construction workers. The land on which your construction will take place can often be purchased with these funds. You can secure a loan with the land if you own it outright. The duration of a construction loan is generally between 12 and 18 months, as this time frame is sufficient to cover the duration of the construction process. However, after construction is finished, some loans transform into permanent mortgages without any more action on your part. Construction loans are not backed by the property’s title like a standard mortgage is. Because of this, getting a construction loan is a more involved procedure than getting a mortgage. Before extending any credit, a lender will want to look at your budget and building ideas. You should also include a rough budget and schedule for the building process. Even after getting the green light for a building loan, you won’t get the whole amount at once. Instead, the lender will pay your builder in a series of draws as the work progresses through different building phases. Construction loans function like a line of credit in this respect. The lender will send an inspector to check on the progress of the building before each draw is released, and the release dates are based on the construction timetable. Interest payments are typically only due on the amount of money that is actually used rather than the whole loan amount. After construction is complete, you may be able to refinance your construction loan into a mortgage, depending on your lender’s policies. Mortgages (sometimes called “end loans”) are available to pay off construction loans if this is not possible.

Types of construction loans

Construction-to-permanent loan

A construction-to-permanent loan is a sort of hybrid loan that combines a construction loan with a standard mortgage. The lending institution will turn the construction loan into a regular mortgage when the building project is done. There is only one closing with a construction-to-permanent loan; hence they are also referred to as “single-close construction loans.” When the transition from construction to permanent is complete, the loan changes to a more conventional mortgage for 15 to 30 years. Afterward, you will make payments that include the interest and the principal. At that time, you’ll decide whether you want a mortgage with a fixed rate or one with fluctuating rates. You can also apply for an FHA construction-to-permanent loan, which has more lenient approval requirements and may be a better fit for some borrowers, or a VA construction loan if you qualify.

Construction-only loan

The borrower of a construction-only loan must either pay off the loan in full by its maturity (usually within a year) or get a mortgage to finance the home’s ongoing maintenance and upkeep. Borrowers have to make interest payments on the monies obtained from these construction loans, which are disbursed based on the percentage of the project that has been completed. If you plan to get a permanent mortgage at some point, construction loans may cost you more than a conventional mortgage. Closing costs can add up to thousands of dollars, so avoiding incurring another set of expenses is quite beneficial. There’s also a chance that your money situation could get worse as the building goes on. The inability to get a mortgage down the road could prevent you from moving into your new home in the event of job loss or other financial difficulties.

Renovation loan

The purpose of a renovation loan is to provide finance to borrowers who require it only to make repairs to or additions to an existing structure. Borrowers can apply for these loans whether they already own the property or plan to buy it. Similar to a standard mortgage, renovation loans can finance both the purchase and restoration of an existing home. Therefore, the loan amount is determined by the home’s projected after-repair market value. It is best for investors or homeowners who want to make significant changes to a “fixer-upper” property.

Owner-builder construction loan

When the borrower doubles as the home builder, the loan type is called an “owner-builder loan,” which can be either a construction-to-permanent loan or a construction-only loan. Because of the complexity of building a home and the experience required to comply with building rules, most lenders will not allow the borrower to act as the builder. Those lenders who do will typically need the borrower to be a professional builder with a valid license.

End loan

End loan means “homeowner’s mortgage” after the home has been constructed. Loans for construction are typically taken out during the building process and returned once construction is finished. When the end loan is paid in full, the borrower will have only the ordinary mortgage to pay off.

How to get a construction loan – main requirements

Getting a loan authorized is a prerequisite to obtaining the funds needed to initiate a building project. Since a home does not back the loan, the underwriting process is often stricter than for mortgages and other loans. Lenders will have to look through architectural blueprints, an estimated construction timetable, and a suggested budget in addition to the usual borrower standards. The following are some of the requirements that lenders look at before giving out construction loans in Los Angeles:

Good to excellent credit: Lenders will often want a credit score of 680 or higher for a construction loan. This is to mitigate the risk associated with providing the loan. However, some lenders may need a credit score of 720 or above. Planning on getting a construction loan to build a home? You might want to work on your credit beforehand.

Enough income to pay off the loan: To qualify for a construction loan, you’ll need good credit and proof that your monthly income is sufficient to pay both your existing debts and the new loan. Your lender will need to see financial statements or other proof of your annual income to verify this claim.

A low debt-to-income ratio: All of a borrower’s monthly loan payments are compared to their gross monthly income to determine the DTI ratio. Generally speaking, the lower your DTI, the more money you should have after taxes and bills to put toward your monthly construction loan payments. Lenders may often need a DTI ratio of no more than 45% when offering construction loans to improve the probability that borrowers will be able to make payments.

A down payment of at least 20%: A minimum 20% down payment is typically demanded of borrowers applying for a construction loan. However, most lenders call for a higher percentage, typically between 25% and 30% of the overall project cost. If your down payment is less than 20%, your lender may ask you to pay private mortgage insurance (PMI).

Project and construction budget approval: Lenders need as much information as possible to mitigate the risks associated with financing a home construction project. Suppose you want the bank to give you a loan. In that case, you should provide them with the following documents: a deed (or purchase offer) for the land, detailed blueprints and specifications, a detailed line-item budget in the bank’s preferred format, a payment (draw) schedule, and a signed construction contract with change order provisions.

The builder’s or general contractor’s approval: In a similar vein, you’ll need to provide the lender with proof that both your architect and builder meet the requirements and are properly licensed and insured. A builder’s insurance certificate, resume, and evidence of financial stability may all be required. Also, make sure to detail the roles of everyone from the architect to the general contractor to the client.

The bottom line

Building a house from the ground up allows for limitless possibilities in terms of design. However, building something can be a pricey endeavor, much like purchasing a home. Fortunately, construction loans can provide the money needed to purchase land and pay for the materials and labor involved in building a home. But unlike a regular mortgage, the process of applying for and getting approved for a construction loan can be long and complicated.