Construction Financing Definition
A construction loan, also known as a building loan, construction mortgage, or development loan, is a short-term loan (typically less than four years) is used to fund the construction of residential or commercial buildings. Land development and building construction are covered by construction loans.
Construction loans feature higher interest rates and are usually secured by the property being financed. A construction loan funds are paid in a series of advances or draw based on a predetermined timetable or milestones. The cash flow created by the completed building is usually used to repay these loans with permanent financing (mortgage).
How construction loans work
If you’re building a building, you’re probably already thinking about a vacant lot. As a result, most construction loans cover both the cost of the land and the cost of the construction. Because of the increased complexity, building loans require greater lender involvement than traditional home/office loans (mortgages). Lenders will want to see your construction plans, which should include a schedule, permits and a budget. Land financing can occur only if the site plan is already approved by the city.
After you’ve secured financing, the lender pays you in stages as the project progresses. The frequency of payments is arranged into a draw plan that the lender and you (the builder) agree on. Before releasing additional funds, the lender normally checks on the progress of the work at each scheduled milestone prior to releasing the additional funds.
Construction loans are interest-only which means you only make interest payments on the amount already advanced until the construction is completed. The original loan balance is only repaid once the construction is complete. These loans are paid back in a lump sum (normally within a year of completion) either from the proceeds of the sales of the condos or by taking a mortgage on the apartment or commercial rental buildings.
Advance Stages/ Draw Schedule
Below is an example of draw schedule:
Before each draw is advanced, an inspector and/or cost consultant may visit the property before funds are released.
Types of construction financing lenders; Pros & Cons
There are three types of construction financing lenders which any of them has pluses and minuses.
- Large financial institutions, such as big banks
- Smaller financial institutions, such as credit unions
- Specialized private companies involved in construction funding
So, let’s get into each of them with more details. So, you can make a comparison and eventually make your due diligence decision.
Large financial institutions
Rate: The big banks often own institutional construction financing for residential and commercial structures in larger centres, as they will finance these agreements at 2 to 3 percent over the prime rate
Flexibility of product: lowest flexible products
Loan to value (LTV): Most financial institutions require you to purchase the lot with your own funds, and then they finance 60% to 75% of the construction cost depending upon the project and developer experience.
Fees & Payment Structures: When dealing with large banks, you may be required to begin making monthly principal and interest payments on the total amount that will be funded in the future rather than just the interest. During construction, this might make monthly cash flow tight. There are normally only a few fees, but they can add up to 1% of the total loan amount.
Construction Draws: Construction draws are allowed by all lenders. This means they will grant you money based on the percentage of the project that has been finished. Banks normally limit mortgage draws to three or four.
Final Idea: Construction financing with a bank is often too restrictive and requires too much cash on hand
Smaller financial institutions
Rate: Smaller financial institutions and credit unions will provide more construction financing in the more rural or less prime market areas and will provide construction mortgages more in the prime plus 4% to 6% range.
Flexibility of product: More flexible products than large financial institutions
Loan to value (LTV): Credit unions typically finance 50% of the lot value or 50% of the lot purchase price, followed by 75% – 80% of the building cost or 80% of the future value.
Fees & Payment Structures: Credit unions frequently have monthly interest-only payments and a fee of about 0.85 percent of the projected funding amount.
Construction Draws: Credit unions sometimes offer unlimited draws and require 10% holdbacks on the funds disbursed.
Final idea: Credit unions provide a more flexible alternative on paper, but the timeframe might be lengthy.
Specialized construction lenders
Rate: Specialized construction lenders or private lenders will provide construction loans on 6% to 12% interest rate on both residential and commercial properties.
Flexibility of product: Significantly more flexible products
Loan to value (LTV): Typically, specialized construction lenders finance 50 to 65 percent of the lot value, followed by 70 -85% percent of the future value.
Fees & Payment Structures: With specialized construction lenders, you typically make interest-only payments deducted from the next financing draw. This reduces the need to take money from your pocket. A 2% to 4% lender broker fee on the full funding amount is normally charged upfront to the borrower prior to any funds being released.
Construction Draws: Specialized construction lenders usually allow you to do as many financings draws as needed.
Final idea: Despite the higher rates, most people choose to go with specialized construction lenders. Private or specialized lenders provide greater flexibility and quicker turnaround than other lenders.
About BPF Solutions
BPF Solutions is a boutique Consulting firm, specializes in business, real estate and construction financing, Accounting, and advisory services. In addition to our specialty in the financing, we work with you to create an innovative process that streamlines design and construction to save time, reduce costs and eliminate headaches. We form the right team to get the job done on budget and on time. Every time.
Here are key steps we take to ensure that your construction loan is secured:
- First meeting to discuss your project and assess your construction loan needs
- Perform preliminary due-diligence and determine project feasibility
- Provide options or solutions that meets your needs
- Gain and alignment on the moving forward approach
- Complete full due diligence, documentation and underwriting process
- Work with our network of lenders to secure financing
- Arranging a meeting between the source of the capital and yourself (if needed)
- Present the entire financial package and discuss a potential deal structure
- Receive the first draw and the following based on the project progress and timeline
Start your next project with us. Please contact 1.877.800.2731, 1.416.222.2909 or email us at firstname.lastname@example.org
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