Construction Business Loans: What Is It and How to Get One
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Construction business loans, sometimes referred to as commercial construction loans, are short-term loans used to finance the building of a residential or commercial structure from the ground up.
There are several types of construction loans available. The best choice depends on the scope of your project and how the funds will be used.
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, shopping center and other real estate assets. Depending on the lender, loans for larger projects may also be referred to as commercial construction loans.
Some construction loans can be used solely for the renovation of existing structures or to install upgrades, such as a solar power system.
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.
Construction loans vs. mortgages
While both construction loans and traditional mortgages deal with real estate, there are several differences between the two:
| Construction loans | Mortgage loans |
|---|---|
| Secured only by land | Secured by both property and land |
| Disbursed in a series of draws | Disbursed in a single lump-sum payment at the origination of the loan |
| Repaid over a shorter term, as little as six months | Repaid over a longer term, usually 15 or 30 years |
| Require monthly payments of accrued interest only | Require monthly payments of principal plus interest |
| Options for commercial builders and homeowners available | Generally intended for homeowners when used to purchase a house |
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:
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- Land acquisition
- Hiring construction workers
- Construction materials
- Renovations
- Professional fees (e.g., architecture and design, appraisal, inspection, project review)
- Subcontractor fees
- Landscaping
- Commercial external displays (e.g., signage)
- Permanent fixtures (e.g., flooring, lighting)
- Builder’s risk insurance
- Appliances
- Closing costs
Be sure to discuss with your lender the types of expenses the construction loan can finance. Various lenders will have different rules about uses for which the funds are eligible and ineligible. For example, in general, construction loans cannot cover home décor and furniture. Some lenders will not offer financing for condominiums or won’t cover closing costs after the construction of the property is completed.
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 25%. Interest rates are also typically higher than those for a traditional mortgage.
Some types of construction loans can be refinanced into a longer-term loan, like a mortgage, with terms of 15 to 30 years, but these loan types are generally more suited to people who plan to live in the home than contractors and developers.
How construction loans are disbursed
Construction loans are different from other types of loans because the total funds are not issued all at once, but are disbursed in a series of payments throughout the construction timeline.
The issued funds follow a disbursement schedule. Sometimes each draw will correspond to a construction milestone, such as the completion of the foundation or the erection of the building frame. Some lenders prefer to disburse the funds evenly throughout the life of the loan, while others 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 the borrower draws. If a business owner secures a construction loan for $100,000 and only draws $10,000, interest will only apply to the $10,000 drawn.
Requirements 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) — an agency overseen by the Department of Housing and Urban Development (HUD) — and the U.S. Department of Agriculture (USDA).
The requirements for getting a construction loan will vary depending on the lender, including the amount of down payment and the minimum credit score. Lenders will need information on your construction plans to determine your eligibility for a loan.
Down payment
Down payments for commercial construction loans are often up to 25% and vary by lender and based on the borrower’s qualifications. In rare cases, lenders 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 dimensions and elevation measurements of the construction project, as well as a legal description of the building lot that states its boundaries and dimensions.
You may also have to supply a list of the building materials, their quality and cost.
Credit score
You’ll generally need a personal credit score of at least 600 to be approved for a construction loan, and many lenders prefer to work with borrowers whose scores are at least 650. Applicants with higher scores are more likely to be approved and to qualify for lower interest rates.
Debt-to-income ratio
A business’s debt-to-income (DTI) ratio is a common indicator of a borrower’s ability to repay a loan. You should aim for a DTI ratio of 43% before applying for a construction loan.
Types of construction loans
Borrowers should know which type of construction loan they need — each loan type is for a specific purpose, and terms can vary from one type to the next.
Construction-only loan
The proceeds of a construction-only loan can only be applied to the construction costs of a property.
During construction, the borrower only needs to pay accrued interest, and after the property is built they will either pay back the whole loan or refinance the construction-only loan into a mortgage.
Construction-to-permanent loan
Construction-to-permanent loans combine a construction loan and a traditional mortgage. These are generally used by people who want to live in the home, rather than builders and development companies.
After the construction on the property is completed, the lender that issued the construction loan will convert it into a traditional mortgage loan. Since construction-to-permanent loans require only one loan closing, they are commonly called single-close construction loans.
Renovation loan
Renovation loans are available to borrowers who need financing for the renovation or expansion of an existing property. These loans are available to borrowers who currently own the property or are looking to purchase it.
End loan
An end loan is a long-term loan that borrowers use to repay a short-term construction loan after the project is complete and the interest-only payment period ends. At this point, borrowers must pay back the entire short-term loan and can use a long-term end loan to do so.
SBA 7(a) loan
The Small Business Administration (SBA) 7(a) loans are available in amounts up to $5 million and can be used for a wide range of purposes, including machinery, working capital and acquiring real estate, including land. The loan proceeds can be used for construction costs to improve real estate, such as materials and hiring workers. These loans are intended for business owners who are not able to obtain funding elsewhere. The SBA places a cap on interest rates, which helps keep costs affordable.
SBA 504 loan
The SBA also offers 504 loans up to $5 million (and even $5.5 million for certain borrowers) that are intended to finance the purchase of business assets such as commercial real estate or heavy machinery. Specifically, these loans can finance the purchase or improvement of land and buildings, the construction of new facilities, the purchase of new machinery or refinancing debt that was used for any of those purposes. These loans are unique in that they consist of three parts: a 10% down payment from the borrower, a 40% loan from a certified development company, and a 50% loan from a bank or credit union. SBA 504 loans have terms of 10 to 25 years and come with low rates.
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 you to spread the cost of an equipment purchase over several years. Equipment financing loans are particularly well suited to construction businesses that need costly equipment to operate.
- Working capital loan: Working capital loans are meant to cover short-term business costs such as rent and payroll. These loans can be useful for construction businesses that need financial relief during cash crunches.
- Invoice factoring: Invoice factoring allows construction business owners to get 70% to 90% of the value of their unpaid invoices, which can help with cash flow but often comes with high costs.
- Merchant cash advance (MCA): MCAs offer amounts up to $500,000 with lenient credit requirements. These are ideal for business owners who do not qualify for a construction loan, but they can be costly.
- Line of credit (LOC): Similar to construction loans, business LOCs are not issued in a single payment, but can be drawn on as-needed basis. You can then borrow up to the full amount again after repayment. LOCs are ideal for short-term working capital and emergency expenses.
Frequently Asked Questions
A construction loan may be able to finance the entire cost of constructing a piece of property or renovating an existing one.
Construction business owners can also consider equipment financing, working capital loans and SBA loans.
Yes, there are construction loans for builders in which the contractor can secure financing directly from the lender.
Some types of construction loans are available directly to homeowners. In this case, the homeowner receives the funds and is then responsible for paying the contractor for the construction of the property.
Some borrowers may qualify for zero percent down on certain types of construction loans, but down payments on new construction loans are typically high, up to 25%.
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.
Construction business owners should aim for a credit score of 600 or higher, and a low debt-to-income (DTI) ratio. Borrowers with bad credit are more likely to have high interest rates. You are also likely to need a down payment of up to 25% of the loan value to qualify.