Construction projects are capital intensive in nature and builders who undertake such projects often need to make a huge upfront investment. Construction finance makes the task of funding a project easier and allows a builder to utilise their money for purposes such as marketing their project and streamlining other operations.
This article provides information relating to which constructors are eligible for construction finance and how you can improve your chances of being granted a construction loan.
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What is Construction Finance?
Typically, construction finance is a short term loan which is used to cover the costs of a building such as a commercial project or a private home. The term of this loan is usually set at around a year to provide sufficient time for the builder to complete the project. Sometimes businesses take out another loan commonly referred to as an ‘end loan’ to pay off the construction loan.
In this way, the earlier loan is refinanced using the new loan at the end of the construction process. The new loan usually provides better repayment terms and spreads repayment of the loan over a longer period, such as 30 years.
Qualification for a Construction Finance
Mortgage lenders and banks are often hesitant to give away construction loans for several reasons.
To fund a construction project, the lender must have faith in the ability of a contractor to complete the particular project which needs financing. Financial institutions which approve the necessary construction finance do so on the basis of the value that the project will possibly hold upon completion.
If the property rates fall, or the builder doesn’t do a satisfactory job, it may reflect poorly on the bank or lender which chose to fund the project. For this reason, many construction finance providers carefully evaluate the eligibility of a contractor to qualify for funding in a bid to protect themselves from an unfavourable outcome. Banks especially are known to impose strict requirements that must be met by those who apply for a construction loan.
Involvement of a Qualified Builder
A licensed general contractor is a qualified builder with a reputation for delivering quality projects. Loan applicants who are owners as well as builders, or intend to act as their own general contractor, may find it difficult to make a convincing pitch to a financial institution to acquire funds for their project.
The Lender Needs Detailed Specifications
Banks or lenders request the contractor to provide details regarding the material which is being used for the purpose of construction as well as other important particulars such as floor plans, fire safety precautions, ceiling heights, type of home insulation, amongst many others. Any loan applicant must therefore gather all relevant information regarding the project that may be needed by a lender.
An Appraiser Must Estimate the Value of the Building
It may be difficult to accurately predict the value of a building which does not even exist. However, the value of the land on which the building is to be constructed along with other building specifications need to be evaluated by an appraiser and the findings must be reported to the lender.
Buildings and locations which are similar in size and features to the project in question must be compared against the calculations made by the appraiser. This should serve as a confirmation to the value determined by the appraiser.
Large Down Payment
The minimum amount that you need to put down for a construction loan is typically 20 percent and may even go as high as 25 percent. From the perspective of a lender, this is necessary as it reflects the intent and resolution of a builder, and also speaks of their ability to complete the project and not abandon it if things go wrong. It also acts as a safeguard in case the building does not have as much value as was expected upon completion.
Applicants who have a positive credit rating and are also able to meet the criteria mentioned above, should not face much difficulty in getting approved for a construction loan.
Additionally, however, lenders may ask for information relating to income to ensure that the borrower can afford the mortgage repayments. This is the same information which is expected of a borrower of any type of credit.
How Does Construction Finance Work?
When a loan applicant meets the eligibility criteria and their request for a loan is approved, the lender begins to pay out the money promised as per the loan agreement. Instead of providing the money up-front, a schedule of payment instalments is created.
Draws can also be thought of as the designated intervals between subsequent instalments of credit borrowed in order to continue the construction of the project. Throughout the construction of a project, there may be several withdrawals. The payment schedule which the lender and borrower may agree upon, varies from provider to provider.
For example, a lender may decide to give away 10 percent of the loan amount when the loan closes and the next 10 percent after the area is cleared or the foundation of the building is laid. The next instalment may be provided when a particular slab has been laid or the house has been framed. Usually the final instalment is given when the project is on the verge of completion.
The frequency of providing instalments as well as the amount which is to be given away in each instalment is a topic of negotiation between the borrower and the lender. The buyer’s down payment is typically the first draw which puts the buyer’s money at a greater risk than that of the lender. Before each instalment of the loan is released, an inspection is carried out to make sure that the construction of the project is proceeding as per the plan.
Construction Loan Rates
As with all other loans, interest needs to be paid on the money which is borrowed in the form of a construction loan. Construction loans are generally variable rate loans which means different rates of interest will be payable at different stages of the project.
For more information regarding construction finance, it is advisable to get in touch with several lenders and determine which is the most suitable loan for your project.