What are construction loans and how do you go about getting one?
So: you’ve found a great site, have a great idea for a construction project, and you may have already drawn up some plans for the building.
But have you answered the biggest question of all: do you have adequate funding for your real estate project?
If this has you scratching your head, then you should sit down and consider construction financing.
What is construction finance?
In general, construction finance refers to a type of bridge finance used to pay off the construction, refurbishment, or even repurposing of a structure or a piece of real estate.
While the term itself is a catchall term for any form of finance related to construction and property development projects, it most commonly refers to construction finance loans.
These short-term loans are taken out to ensure a construction project’s completion.
Also referred to as:
- asset finance (if used primarily for materials and equipment) or
- self build loan (if it covers the full cost of construction for a construction project,) those who take out construction loans need to pay their lenders back after a certain amount of time with interest.
Construction loans may be used for the following purposes:
- Purchase of equipment and materials;
- Hiring and training of a labour force;
- Expand or refurbish an existing property, particularly those used for commercial or industrial purposes; and
- Repair existing structures in the event of damage caused by natural or human-made disasters, including earthquakes, fire, and flooding.
How do construction loans work?
Are you considering these short-term loans for the first time? You may wonder how construction loans work or what makes them different from other forms of bridging finance.
Unlike open or closed bridging loans and development financing, the amount given for a construction loan is not based on the property’s value upon completion.
Instead, the loan amount is normally based on how much money a borrower needs to develop a property or to finish construction.
Applicants draw the funds against a build schedule agreed upon with the lender. These are usually a bank or a similar licensed and approved financial agency.
The latter scrupulously monitor the progress of the building project at every stage of construction. This ensures that progress is on track for successful completion and stays within its stated budget.
Who can avail of a construction loan?
Anyone with the intention of investing time and money into property development, real estate, and construction may avail of these loans. These include the following:
- Individual homeowners seeking funds for the construction of a new home or the renovation or refurbishment of an existing residence;
- Business owners who need the funds for the renovation or expansion of existing commercial or industrial property or the construction of new headquarters or branch establishments; and
- Main contractors and subcontractors for a construction project.
One can also be eligible for a construction loan if you:
- Raise applications – both certified and uncertified – for payment;
- Raise invoices for drawn payments for incomplete contracts; or
- Work under the Construction Industry Scheme (CIS) and have a valid unique tax reference (UTR) number.
What type of construction loans are available?
In essence, a bank or lending agency offers either a residential or commercial construction loan.
1. Residential Construction Loans
Home construction loans cover those who are planning to build a new house themselves instead of getting a builder or construction company to do it for them.
Requirements may differ among banks and lending agencies. Given how these self-build loans pose a certain level of risk, the following criteria need to be met by anyone applying for a residential construction loan:
- Proof that a qualified builder or construction company will collaborate or work with the homeowner on the construction project. In all cases, this needs to be a licensed general contractor with proven experience in the field. It is unlikely that the bank or agency will approve the application without a licensed builder’s involvement. The exception is unless the homeowner has the relevant experience.
- Detailed plans or blueprints of the home you intend to build. These have to be done properly and to scale by a professional architect. The blueprints should include details regarding the materials, timeline, number of rooms, ceiling height, insulation, and plumbing and electrical wiring plans.
- An estimated value of what the completed home will be worth. Homeowners can ask the assistance of an appraiser for this. The estimate will be based on the submitted plans and comparative values of other homes within the vicinity.
- The amount of money the homeowner is willing to invest in the construction. Similar to a mortgage, lending agencies need to see a deposit for the construction. However, the difference between this loan and a mortgage is that your lender would like to see a much larger percentage of the overall building cost, or somewhere between 20 to 25% of the total.
- An exit strategy for paying off the construction loan or how you will pay off the mortgage. If you need a mortgage to cover the costs of your new home even after construction is done, you need to prove that you can pay it off. Usually, this involves proof of income and employment. However, for the most part, be warned that some banks may ask you for a secondary down payment.
2. Commercial Construction Loans
Construction loans taken out by a business or a large-scale contractor for commercial property development projects may fall into either one of two loan term categories: shorter-term and longer-term.
2.1 Shorter-term construction loans
In principle, these shorter-term loans bridge the period between construction and when the completed project is refinanced on the permanent property market. From there, a business can then transition between high-value short-term construction loans before getting into a more long-term fixed-rate mortgage to free up their property’s liquidity.
Loans of this nature help build a company’s credit and operating history on a project; this enables them to secure better lending rates later on.
On average, the bridging loan-to-value (LTV) for these loans is pegged at 75%. Meanwhile, the monthly interest rate is calculated between 0.5 and 2%.
2.2 Longer-term construction loans
These, on the other hand, are considered non-bridging development finance. They apply to bigger loans and financial products that are more applicable to large-scale construction projects.
While these are more complex in nature, longer-term loans tend to have lower borrowing rates. Also, they allow contractors and business owners to borrow larger sums of money for commercial property development.
In this case, LTV is pegged between 70 to 80%. However, since longer-term loans pose a higher risk, this comes with a caveat. The interest rates for long-term loans are much higher, going so far as 4 to 15% per annum depending on both financial factors and project experience.
What do I need to submit for a construction loan application?
In practice, one should note that applying for a construction loan is more difficult than securing most other forms of development financing.
For instance, getting construction loan approval is more difficult than a traditional mortgage. The reason? Banks take on more risk during the building phase, given that there is no asset for security.
As a result, construction loans are usually subject to stricter terms, going so far as to ask for a down payment before disbursing funds.
While we have presented some of the requirements asked from those looking into home construction loans, most lenders will also ask applicants for the following items:
You will need to start building with some of your own money as many banks or lending agencies ask applicants for a down payment equivalent to 20% or more of the total project cost. This looks – and is – steep. However, this practice assures lenders that you are properly invested in the project and won’t bail if major issues arise.
Actually owning the land you intend to build on defrays this a little and serves as leverage towards the required amount.
Note that the actual amount of the down payment depends on the total cost, including the land value/real estate value and what you intend to do with the funds.
A good credit history
Lenders want to see your personal credit history regardless of whether you’re looking into a home construction loan or one for a small business.
Ideally, your personal or business credit score needs to be between 891 to 960 (Good) or, better yet, between 961 and 999 (Excellent.)
Any lender considers your financial documents a barometer for your ability to pay loans back. These include records of any current or past debts, payment history, as well as any other loans on your property.
Regardless of whether your construction project is residential or commercial, your bank or agency will also ask for your bank statements, tax returns, proof of income, and any other viable assets.
This applies both to the applicant and the builders or contractors they’re working with. Public information on their reputation counts especially where builders are concerned.
Lenders will look at vendor and subcontractor reviews on and offline, as well as their portfolio of previous projects. Your builder ought to be forthright when asked to give proof of their good reputation.
Construction plans and blueprints
As stated earlier, for home construction loan applicants, banks and other lenders will ask for detailed building plans drawn to scale together with the bill of materials, site layout, human resources component, and technical details.
As with a residential construction loan, it can be hard to discern the actual finished development value of a property you haven’t even broken ground for.
Note that your application has a higher chance for approval with a good appraisal. You may choose to have a third-party appraise the potential value of a home or a commercial structure. However, it’s more likely that your lender of choice will work with an appraiser to analyse the details to determine its future worth.
What happens next?
Upon approval of the application, the bank or lender will begin paying out the loan amount agreed upon. All disbursements of funds, referred to as draws, will follow a schedule agreed upon by both parties.
Remember that banks normally release the first of these draws or prepayment within 24 hours from approval of the application.
Loans are usually charged interest based on the amount of money borrowed. However, one should note that construction loans are interest-only loans. This means you don’t have to repay the entire loan amount, just the loan interest.
Besides interest, are there any other fees I need to pay when taking out a construction loan?
Here in the UK, construction finance pricing will also include the following fees and charges:
- Service charge equivalent to up to 0.5% of the total LTV;
- Discount charge, essentially around 3% above the BoE base rate; and
- An annual fee equivalent to around 0.5% of the facility limit.
Please note that percentages and rates are dependent on which lender you choose. Therefore, be sure to check first before entering any transaction.
How do I choose a good bank or lender for a construction loan?
So far, we have clued you in on what you need to present when you apply for a loan. Afterward, see which bank or lending agency best fits for your needs.
Consider the following criteria when making a choice:
Look over the available options
Check your bank if they offer options for construction loans or similar development finance products. Not all banks may have the financial products you need to build. So you would also do well to consider credit unions and other reputable lending agencies licensed to operate in the UK. They may have what you’re looking for, but you should also look into what fees they may charge and their interest rates.
Go over your lender’s track record
Remember what we said about reputational capital? It goes both ways.
Check if the lender you have in mind has experience in construction financing or, better yet, ask other developers for good references.
Your own neighbourhood may have the answers
You may not need to look too far to get a construction loan. Check around your local community and even your neighbours for banks, credit unions, and agencies they trust for such transactions.
Talk to us
While we’ve given you a comprehensive look at what construction loans are, what financing you can avail of for your construction projects, and what to expect when you file your application, we know you’d like to learn more about a loan that works for your specific needs.
Give us a call at 0808 301 9509 or contact us here to talk about your main requirements. Browse through our website to learn more about bridging loans and other related financial products.