Construction Business Loans: What Is It and How to Get One
Construction business loans are short-term loans that are used to finance the building of a residential or commercial structure from the ground up. Due to their specific purpose, construction business loans are unique in their funding and repayment process. Specifically, funds are disbursed in a series of draws instead of a single lump-sum payment and can sometimes be refinanced into a long-term mortgage loan after construction is completed.
Learn how construction loans work, how to get one and the different types.
What is a construction loan?
A commercial builder can secure a construction business loan, a type of short-term financing, to cover the cost of building real estate property. Examples of real estate property include a new home, multi-family unit, hotel or some other real estate asset. Some construction loans can be used solely for the renovation of existing structures or to install upgrades, such as a solar power system.
While both construction loans and traditional mortgages deal with real estate, there are several differences between the two. Construction loans are secured only by the land, whereas mortgage loans are secured by both the property and land. Moreover, construction loan proceeds are disbursed in a series of draws throughout construction rather than a single lump-sum payment at the beginning. A construction loan’s repayment terms (sometimes as short as six months) are notably shorter than a mortgage loan (usually 15 to 30 years). Monthly payments for construction loans are typically for accrued interest only while mortgage loans factor interest and principal into the payment installments.
What construction loans cover and don’t cover
Construction loans can cover a range of expenses related to the construction of commercial and residential properties. Some uses may include:
- Land acquisition
- Construction materials
- Professional fees (e.g., architecture and design, appraisal, inspection, project review)
- Subcontractor fees
- Commercial external displays (e.g., signage)
- Permanent fixtures (e.g., flooring, lighting)
- Builder’s risk insurance
- Closing costs
Eligible and ineligible use of proceeds can vary by the lender. Construction loans cannot cover home décor and furniture. Some lenders, for example, will not offer financing for condominiums or won’t cover closing costs after the construction of the property is completed. Be sure to discuss with your lender the types of expenses the loan construction can finance
How do construction loans work?
Construction business loans typically carry short terms of six to 24 months. Lenders take on higher risk since there is no existing property to secure the construction loan. To compensate for the higher risk, borrowers will typically need to make a down payment of up to 20%. Depending on the type of construction loan, it can be refinanced into a longer-term loan, like a mortgage, with terms of 15 to 30 years. You will also find that interest rates are typically higher than a traditional mortgage (although, creditworthy borrowers may be eligible for more favorable rates).
Construction loans are different from other types of loans because the total funds are not issued all at once, which is the case for many personal loans — rather the funds are disbursed in a series of payments throughout the construction timeline. The issued funds follow a disbursement schedule, with each draw sometimes a construction milestone, such as the completion of the foundation or the erection of the building frame. The funds can be disbursed evenly throughout the life of the loan whereas some lenders may allow qualified borrowers to customize the disbursement amount and schedule based on the cost demands per month.
Keep in mind that interest applies only to the funds advanced. If a business owner secures a construction loan for $100,000 and only draws $10,000, interest would only apply to the $10,000 drawn. Repayment on construction loan repayment is typically interest-only payments, whereas other types of loan installments include both principal and interest.
How to get a construction loan
Construction finance for builders is available through traditional brick-and-mortar banks, online lenders, the U.S. Federal Housing Administration (FHA) and the U.S. Department of Agriculture (USDA). Similar to other lenders, down payment and credit score requirements can apply and will vary by lender. Construction loan lenders will also need information on the construction plans.
Down payments will typically range up to 20% and will vary by the lender and borrower’s qualifications. Although rare, there are cases where lenders may issue construction loans with no down payment.
Specific construction plans
During the underwriting process, lenders will require a copy of your building plans. These documents should show the dimension and elevation measurements of the property being built. A list of the building materials, their quality and cost may also be necessary. Borrowers should supply a legal description of the building lot that states the boundaries and dimensions, too.
Construction loans may be available to borrowers with credit scores as low as 620. Although, higher score applicants are more likely to receive approval and qualify for lower interest rates.
A business’s debt-to-income (DTI) ratio is a common indicator of a borrower’s ability to repay a loan. Borrowers should aim for a DTI ratio of 43% before applying for a construction loan.
Types of construction loans
There are several different types of construction business loans, each with its own intended purpose and terms. Borrowers should be conscious of which type of construction loan they use, as some may only apply during the construction phase and may need to be refinanced into a longer-term loan.
The use of proceeds from a construction-only loan goes only toward the construction of a property. After the property is built, the borrower will typically refinance the construction-only loan into a long-term mortgage.
Construction-to-permanent loans are a type of hybrid loan that combines a construction loan and a traditional mortgage. After the construction on the property is completed, the lender that issued the construction loan will convert it into a traditional mortgage loan. Since this type of loan requires only one loan closing, construction-to-permanent loans are commonly called single-close construction loans.
Renovation loans are available to borrowers that need financing solely for the renovation or expansion of an existing property. These loans are available to borrowers that currently own the property or are looking to purchase it.
Also called a permanent mortgage, end loans are long-term mortgages that are used to repay borrowed amounts under a previously acquired construction loan.
Alternatives to Construction Loans
If a construction loan is not right for you, consider these alternative small business loan options:
- Equipment financing: This type of financing allows business owners to spread the cost of an equipment’s price over several years. Construction businesses that need to secure costly equipment can benefit from this type of loan.
- Working capital loan: Working capital loans are ideal if you only need financing to cover the short-term costs, such as rent and payroll. These loans can be useful for construction businesses that need financial relief during cash crunches.
- Invoice factoring: Construction business owners can obtain 70% to 90% of the value of their unpaid invoices by selling their invoices to a factoring company. While invoice factoring can tap into cash flow tied up in unpaid invoices, business owners should be wary of high costs.
- Merchant cash advance (MCA): MCAs offer amounts up to $500,000 with lenient credit requirements — ideal for business owners that may not qualify for a construction loan. MCAs, however, can be a costly financing alternative due to their high factor rates.
- Line of credit (LOC): Similar to construction loans, business LOCs are not issued in a single payment — rather, funds are drawn on an as-need basis and are available for reborrowing after repayment. LOCs are ideal for short-term working capital and emergency expenses.
- SBA 7(a) loan: The Small Administration (SBA) offers 7(a) loans in amounts up to $5 million and can be used for a wide range of purposes, including machinery, working capital and acquiring real estate. The SBA places a cap on interest rates, which helps keep costs affordable.
Construction loan FAQs
How can I finance my construction business?
Depending on the construction loan, it can finance the cost of constructing a piece of property or renovating an existing one. Beyond construction loans, construction business owners can consider equipment financing, working capital loans or SBA loans.
Can a contractor get a business loan?
Yes, there are construction loans for builders where the contractor can secure financing directly from the lender. Keep in mind that some types of construction loans are available directly to homeowners — the homeowner receives the funds and is then responsible for paying the contractor for the construction of the property.
What is the minimum down payment on a new construction loan?
Down payments on a new construction loan can range up to 20%. Some borrowers may qualify for zero percent down on certain types of construction loans.
How can I use a construction loan for my business?
Construction loans can be used to construct income-generating property, such as hotels, retail stores and shopping centers. If you need a loan to cover commercial construction costs, such as labor, construction materials and subcontractor fees, then construction financing could work for your business.
How hard is it to qualify for a construction loan?
Construction business owners should aim for a credit score of 620 or higher and a low debt-to-income (DTI) ratio. Borrowers with bad credit are more likely to experience high interest rates. Down payments requirements of up to 20% of the loan value may apply, as well.