What Are the Requirements For a Construction Loan?
Real estate developers and homeowners often need to borrow money to complete a construction project. There are many choices for borrowers to choose from depending upon a few different factors. Loan amount, term, and other considerations play into the decision which type of construction loan works best. Requirements to qualify for a construction loan vary depending upon the lender.
Type of Construction Determines Type of Construction Loan
Borrowing to build a new building and borrowing to build an addition onto an existing building are two different things. New construction, remodels, additions, improvements, and other investments in real estate are funded with different terms and conditions. Listed below are different types of construction projects and the most common financing terms associated as well as resources to borrow from:
- – Building a new residence or commercial property means the project can be financed with longer-term funding. Mortgages for ten to thirty years can be used to construct a residence or commercial property. Residence mortgages can be obtained from mortgage lenders, banks, and other sources that offer extended terms on loans. The long-term funding will normally have the lowest interest rate with monthly payments. Commercial real estate will usually require a larger down payment (20% – 25%) than a residential mortgage requires (5% – 15%) with shorter repayment terms.
- (HELOC) which allows borrowing against the equity existing on the property.
- – Like building an addition onto a residence or commercial property, remodeling can be financed in much the same way. In addition to traditional resources, many contractors offer remodeling project financing through third-party finance groups that specialize in funding home remodels. Depending upon the size of the budget for construction, some projects can be financed with a credit card.
- – Once again, like the other projects listed above, traditional resources can be employed to finance a home improvement project such as putting in a sprinkler system or replacing a roof. Improvement projects like a complete electrical rewiring or installation of a new building-wide air conditioning system can be funded for a longer period than other projects because they are considered longer-lasting upgrades and contribute to the real estate value for an extended amount of time.
- – Rental property is considered commercial property and it garners different financing terms than a private residence receives. As a commercial property generating income, lenders often ask for a larger down payment with shorter repayment terms. Mortgage companies, banks, and other traditional sources can be accessed for construction loan funding as well as other third-party lenders like finance companies and hard money lenders.
Qualifications For a Construction Loan
Different borrowers require capital for a construction project for many different reasons. Some basic qualifications can determine if a borrower is suitable for funding. Those qualifications include:
- – Each lender sets their accepted credit rating or credit score range for providing loans. Higher credit scores earn lower interest charges as well as reduced down payment requirements. Lower credit scores will result in higher interest charges and larger down payments. The length of the financing may also be affected by a borrower’s credit score.
- – The down payment available to reduce the total amount of the construction project to be funded plays a big role in determining interest rates, length of contract, and other important conditions for the loan. Most residential real estate construction loans require between 10% to 20% down payment and commercial loans go a little higher toward the 20% to 25% range or higher. Funds borrowed from private sources and hard money lenders can require even larger down payments in the 30% to 40% range.
- – Sufficient land and building values that are not threatened with being reduced for any reason will be eligible for financing. Lenders prefer real estate with values that will increase over time as that reduces the risk on the loan should the borrower default. Government agencies and other property-controlling entities sometimes condemn property for civic improvements or re-zone property for alternative uses and lenders don’t want to get caught with debt against a property that is losing its value.
- – When a borrower approaches a funding source with a loan request, the funding source wants to ensure that the property is in good enough condition for construction. Home inspection reports and photographs can provide evidence of a property’s condition and readiness for construction. Real estate investors who “flip” properties for profit understand there are some projects that won’t work out because the building or land is too run-down or located in an area that is deteriorated beyond repair.
Requirements For a Construction Loan
Qualifying for a construction loan is not the same as meeting the requirements to receive the loan. Lenders want sufficient information and documentation to ensure all the requirements needed to be met are met with proof or evidence. Documents and data that lenders expect to receive include:
- Credit Report
- Financial Statement
- Tax Returns
- Employment Information
- Proof of Income
- Monthly Budget
- Proof of Property Ownership
- Set of Construction Plans
- Detailed Construction Estimate
- Contractor Licenses, Insurance, Bonding, and background investigation report
Lenders provide checklists of necessary documents and information required for submitting a request for funding. It is important to provide documents and information that is recent and supported by third-party verification of the information whenever possible.
How Do Construction Loans Work?
Once a loan has been established, lenders can put the funds into an escrow account that is used to pay construction expenses with draws against the account. Banks, mortgage companies, and other lenders prefer using an Escrow account so that funds can be monitored as they are disbursed to ensure payments are made properly, in full, and promptly. Escrow agents manage the available funds and only disburse payments when all conditions are met to release funds. Funds are paid out upon receipt of invoices from vendors and contractors and only after the property owner has been satisfied the work has been completed according to the construction agreement or contract.
Construction Loan to Mortgage Loan
Many lenders prefer to start a building project with a construction loan that is later converted to a long-term mortgage. Construction loan interest rates and mortgage interest rates are different with construction loan rates being generally higher than a mortgage rate. The idea is to motivate the construction process by providing an inducement for quick completion of the project. In some cases, longer-term financing can not be established until the project is completed and all costs have been totaled.
Commercial Construction Loans
As mentioned earlier, commercial construction projects are financed under different terms and conditions than residential projects. Commercial loans require larger down payments with shorter repayment periods in most situations. Qualifications for commercial loans vary also as real estate can be owned by corporations or investment groups that have different financial considerations than homeowners. Interest rates on loans can be higher for a commercial project.
Self-build Construction Loans
If a property owner has credentials as a contractor or is in the construction industry as a skilled laborer, many funding institutions will accept them as the contractor to work on the project. Most lenders will ask for credentials and certificates proving the homeowner’s knowledge and experience in construction. Insurance coverage is normally changed to adapt to the construction situation for the project depending upon if the building is going to be occupied or empty during construction.
How Does a Construction Loan Draw Schedule Work?
Rather than put the full amount of the construction loan into an account for the project owner to disburse funds from, most lenders prefer to provide funds on a scheduled basis over the term of the construction. The idea is to control the outgoing funds so that the lender knows construction is progressing according to the original schedule. Interruptions in construction due to natural disasters, work stoppages from labor strikes, or other unanticipated issues can slow or stop a project while the clock is ticking on the interest charged for the borrowed funds. By using draws against the account, only the money used is charged interest, the unused portion of the loan proceeds stay with the lender and don’t have interest charged until they are disbursed to contractors or vendors.
How Does Builder Financing Work?
Builder financing is similar to buying a home that is financed by the home’s previous owner. Some builders have sufficient capital to use some of it to loan out to clients for construction projects and thereby earn additional income from interest fees on the debt. Other builders provide third-party financing for construction projects through companies and lenders who specialize in only funding remodeling or renovation projects. Many lenders specialize in different real estate markets like private/residential, residential rental properties, or commercial rental properties Interest rates can be a little higher in these situations as some builders earn a fee for having their client sign up for builder or third-party financing.
Construction Loans Come In All Shapes and Sizes
Investigating various financing options from lenders when running a construction project can take on a life of its own. There are so many lenders, resources, and options available that it can be difficult to know which direction to go. First-time borrowers are encouraged to look into a variety of different loan packages and loan providers to determine which type of loan will work best for them. Talking with friends, family, neighbors, and associates can be a good starting point as well as looking through the internet. Regardless of the type of loan, borrowers need to know there are many choices available that will work with their individual needs and conditions.