Construction loans are a different creature than many other sorts of real estate or small business loans. Basically, they’re short-term arrangements you use to finance the construction (or major restoration) of a home, business, or other physical property.
Unlike a traditional home loan, the property which would otherwise naturally operate as collateral for the loan hasn’t been built yet, making the loan more of a risk for lenders. Approval often requires submission of detailed plans for the project. And some evidence of the qualifications of those involved – along with in-depth credit checks on the borrower or borrowers.
Once the property is completed, or a specific point on the timeline has been reached, any balance is paid off through the sale of the property. Or it’s refinanced as part of a longer-term mortgage or a more traditional, longer-term loan, often referred to as the “end loan.” We’ll come back to this and a few other terms you’ll want to know before you loan shop for this or similar types of loans.
Types of Construction Loans
Because construction loans are higher-risk than traditional mortgages, they are more difficult to secure. And interest rates tend to be higher. Terms vary widely, depending on the lender and the needs of the builder. Some construction loans are required to be paid in full by the projected completion date of the project. Others may be set up as “interest-only” loans. So that buyers pay only a minimal amount until the project is ready for sale.
Some builders prefer to set up construction loans as a “line of credit”. They’ll secure approval on the total they’ve calculated they’ll need , but only draw funds as required. The advantage to this approach is that they’re only making payments on money they’re actually using at the time, almost like a credit card. Interest only accrues on the amount actually withdrawn as well, saving the borrower substantially over the long-term.
Borrowers new to construction loans may find it strange that substantial down payments – often as much as 20% or 25% to pay down – are often required. Such down payments are intended to establish that the borrower is fully invested in both the short and long-term success of the project. And to “spread out” the risk a bit. In any case, they’re a standard feature of most construction loans.
Why Take Out A Construction Loan for Building Wealth?
There are really only two basic reasons for any construction. You want to use the property or sell/lease the property for profit. Maybe there are a few people out there with artistic souls who simply wish to create large, expensive buildings. Then paint them pink or label them with the names of victims of war crimes. Or simply go all Andy Warhol and pack them with multi-chromatic images of some pop culture figure or another, then walk away. But there can’t be many, surely. Most artists simply don’t make enough for that sort of thing.
Let’s assume, then, that the primary goal of most construction loans is personal use or profit.
Construction Loans for Personal Use
Not everyone can afford to supervise the building of their own home (or serious remodeling). And even fewer of us have the know-how to really do it well. That doesn’t mean it’s impossible, however. Especially with the right vision and a willingness to do one’s homework ahead of time. You don’t have to know how to do everything yourself. But you do need to understand what needs to be done. More importantly, you have to be able to find the right people to make it happen. People you can more or less trust to be the experts at their little slice of the whole.
Personal use means the borrower will be covering the final cost of the project themselves, making the process somewhat similar to what you see at the larger end of personal cash loans. Lenders will look at your personal credit history, current income, and other indicators of your ability and reliability to pay. It can be tricky, and you may have to provide more documentation than with some other types of loans. But there’s no reason to assume it’s not doable if you’re serious. Of course, thinking about the cost of a loan is a must. Loanry can help you find a good lender, a lender who will be open and honest about everything from the beginning.
Whether you’re building from scratch or restoring something which had up until now seen far better days, keep in mind that strategic choices about what you build, how you build, and where you build can mean serious tangible value in the results. To put it another way, make good choices and you’ll have a home that’s worth more than you spent to build it. And which may only continue to increase in value as you live in it, love it, and take care of it.
Even if our intention is to retain ownership and never sell the property, increased value improves your ability to secure future home equity loans. And it strengthens your overall financial situation. It’s impossible to predict the future or issue any absolute guarantees. But homeownership has traditionally weathered all sorts of ups and downs in terms of providing personal security. It’s arguably the most important wealth-building tool in modern American life for the majority of citizens like you.
As a bonus, there’s really no substitute for owning a house you love.
Construction Loans for Business Use
Building for sale or lease is a slightly different game in which the reputation of the builder as a businessman (or businesswoman) comes into play. Obviously, lenders are more comfortable approving construction loans for borrowers with an existing track record of successful repayment, refinancing, or other favorable loan resolution. Even in this dynamic, however, there are multiple variations which may be in play.
If you’re a small business owner looking to establish yourself or expand from your current location, it may be that existing sites prove poorly suited to your needs. It may be that construction targeting your specific needs is the way to go. In that situation, you’re utilizing your construction loan for business use, but not to sell. You’re moving in!
If your expertise is in construction or some part of construction, or if you’re knowledgeable about real estate in your area or otherwise plugged into local business or residential dynamics, then you’re confronted with the same basic dilemma as any other entrepreneur. Do I work for others, or step out on my own? Am I more concerned with security, or do I want to be my own boss, take my own risks, and possibly win (or lose) big?
Unlike many other sorts of entrepreneurs, however, if taking that sort of leap involves construction loans, there’s no working your way up from your home office or garage with minimal risk. They are an “all in” proposition. That part where you might win big or lose big is far more significant in this line of work. But that by itself shouldn’t stop you. Only you know if you’re just as smart, just as skilled, just as determined as the next person.
If you do take that leap, you’ll quickly learn there are things you can’t always control. Choosing the right construction loan shouldn’t be one of them. You have options, whatever your credit history and whatever your professional background. This is the 21st century, and while there’s no reason you can’t sit down with your local bank or credit union and find out what they’re willing to do, that’s no longer your only option.
We maintain a carefully moderated database of reputable online lenders who’ve established themselves as both reliable and willing to work with a wide range of borrowers. Our goal is a bit more comprehensive than helping you borrow; we want to offer you a centralized source of financial sanity, assistance, and assurance. Still, we’re really quite good at the “hook you up with just the right lender” thing. We can also offer you education and insight on a wide variety of loans and related concerns.
It’s something of a point of pride around here, actually.
Wanna order Chinese tonight? Come on, you promised!
Sorry – “take-out commitments” are a bit more involved than that. And you don’t get spring rolls.
Remember above when we said that short-term construction loans often convert into longer-term, more traditional loans after the completion of a project or reaching a certain point on the timeline? Generally (although not always – there simply aren’t that many “always” moments when it comes to construction loans), different lenders provide those long-term mortgages or other loans than the short-term construction loan you are replacing. These short-term lenders often specialize in “bridge loans” and the special circumstances involved. And they prefer to hand off the lower-profit (but less risky) stuff to more traditional institutions.
A “take-out commitment” is an agreement ahead of time between that more traditional, long-term lender and the initial short-term lender that this is, in fact, what will happen.
As you might imagine, this changes the dynamics substantially. On the one hand, it means much greater security for the initial lender. Depending on the specifics of the agreement, they now have a more-or-less guaranteed safety net for what is otherwise a relatively high-risk loan. If the builder for some reason fails to follow through, or supplies don’t show up on time, or it turns out global warming really does flood the earth, they still have a buyer for whatever’s left of the loan and the terms have long-ago been settled.
This doesn’t mean the builder is completely off the hook of course. Ideally, they’re part of the process the entire way. And they don’t flake out, the supplies do show up, and the glaciers melt slowly enough that we can move to higher ground. And both the long-term lender and the initial short-term (or “bridge loan”) lender usually have very specific terms woven i. Which makes sure the onus is on the guy running the project to make things work out – not the lenders’.
Much like the bank doesn’t really want your car, your house, or your firstborn, such terms are all about accountability and security. Not about taking over your business park or remodeled vacation home. They just want those payments to be made and for you to be happy with whatever it is you’ve just built.
Still, I doubt they’d say no to a spring roll. And I love that weird pink sauce…
FHA 203(k) Loans
You’re probably familiar with FHA loans, at least in general. These are loans that Federal Housing Administration guarantees. And they aim at helping first-time homebuyers acquire housing on reasonable terms and at a good interest rate. The FHA doesn’t actually loan the money. But they do act as “back-up” on the loan. Allowing lenders to extend credit on favorable terms to those who might not otherwise qualify.
An FHA 203(k) is similar, but designed to help borrowers secure a loan to purchase a home in need of serious renovation. Especially if located in older communities or areas otherwise identified by federal officials as likely to benefit from a few upgrades. The terms cover not only the cost of the property, but the essential work and supplies necessary to make it move-in ready.
The FHA 203(k) is not available for purposes of “flipping” or other forms of real estate investment. The idea is to put families in nicer, newer homes. Down payments are usually modest and interest rates favorable. Although they will still vary to some extent based on the credit history of the borrower. There are unique fees and paperwork requirements, so prepare yourself to spend some time on small print. It’s a great program, but it’s still the government after all.
Common Risks of Construction Loans
Most professionals already know the ins and outs of construction loans. If you’re an individual looking to start a business or use a construction loan to build or renovate your home, however, there are common potential pitfalls of which you should be aware. Here are three rather important facets of any building project which are harder than you think.
#1: Overseeing Construction
There’s a reason people hire professionals to run a construction site. Watching a few HGTV shows and knowing how plumbing works is a great start and all. But don’t think that just because you know your way around a two-by-four that you have the expertise to handle the project yourself. Not to mention that you probably have a full-time job already.
#2: Hiring a Contractor
It’s essential to find the right contractor for the job, but it doesn’t stop there. Accepting a bid or even signing an agreement isn’t the same as a successfully complete a project. Firing a contractor which does not do a good job is possible. But it causes as many complications for you as it does them. Construction is a job best managed from a big picture, unified process approach. Interruptions and changes are almost always bad – even if they’re otherwise necessary .
While most contractors are no doubt honest, capable people, it’s not unheard of for contractors to walk away from projects. It might be the money, it might be the personalities. Or it might just be that a better offer has come up. This doesn’t only leave you in a tough logistical position. It can cost you substantially as you scramble to find someone to pick up wherever things the contractor did not finish. A job suddenly harder than hiring someone in the first place.
#3: Managing Your Construction Budget
Construction involves a substantial investment of time and resources utilized methodically and efficiently over time. It’s in many ways a constantly shifting puzzle with big, heavy pieces. Failure to manage available resources has been the downfall of more building projects than perhaps any other single factor.
Even if your plans are well-laid, you’ll be dealing with a range of both workers and suppliers at different stages along the way. Neither of which are ever entirely predictable. Then, of course, there’s the weather, which none of us can fully predict, let alone control. Throw in that random county inspector, animal infestation, or late-night vandalism, and you simply never know what might complicate your plans and derail your budget.
Experienced builders plan for the unforeseen and learn to balance flexibility and focus on the endgame.
Wealth Statistics in the United States: By the Numbers https://t.co/KT33IMzLg2
— Wealthry.com | Wealth Shop ? (@WealthryStore) November 10, 2019
Construction loans are a very specific, and at times risky, financial arrangement. They also make most of the building and progress you see in any thriving community possible by providing builders the credit and flexibility necessary to make things happen.
If, after learning more about construction loans, you think this might be the right solution for your plans, let us know. We’ll gladly point you to the right people to help you move forward with your project.
When it’s done, we’ll celebrate. Do you like spring rolls?
Blaine Koehn is a former small business manager, long-time educator, and seasoned consultant. He’s worked in both the public and private sectors while riding the ups-and-downs of self-employment and independent contracting for nearly two decades. His self-published resources have been utilized by thousands of educators as he’s shared his experiences and ideas in workshops across the Midwest. Blaine writes about money management and decision-making for those new to the world of finance or anyone simply sorting through their fiscal options in complicated times.