Construction loans, typically made by a bank or commercial lender to facilitate the financing of a home or commercial building, actually represent a very small portion of the market.
They are short-term loans at higher interest rates than mortgage loans, and are generally available only for 70 to 75 percent of the expected appraised value of the completed project. They are, therefore, subject to some risk based on market fluctuations.
In cases of property offered for sale upon completion, a lower than expected sales price can affect profitability of using a construction loan. Values of a completed project, under favorable conditions, are expected to be substantially higher than the loan amount, resulting in easy payoff. However, in some markets, even the inherent equity might be eroded and construction delays or disputes can add to problems and lead to default.
General Construction Loan Provisions:
- A requirement that title to the tract of land involved be assigned to the lender;
- Some dollar investment on the part of the borrower, as well as a detailed schedule of values for actual construction;
- An assumption that all monies borrowed will be applied to actual building -- materials and labor -- and not utilized for overhead, salaries or other business expense;
- Periodic project draws, based on percentage of completion and verified inspections, that allow staged payment to workers and subcontractors;
- As assumption of personal liability as well as acknowledgement of corporate debt for residential projects. Larger commercial construction loans are often secured by a payment and performance bond, or by another form of insurance or liability arrangement.
- A limited duration, ranging from a few months to perhaps one year, often with one extension available for an additional fee;
- Upon completion of the project the construction loan is expected to be paid off in its entirety. This is accomplished either by selling the property or the borrower getting a traditional mortgage based on the value of the newly completed structure.
Other Funding Sources
Small Business Administration (SBA) construction and improvement loans have varied requirements, and are a viable source of funding if you meet the requirements. Other sources of construction funding include public-private partnerships, "consortium funding" that matches donors to specific aspects of building and development, crowd-funding efforts, cooperative programs that pair for-profit business with educational institutions, service organizations and private foundation grants, and programs that rely, at least partially, on volunteer involvement. Inner-city and urban renewal efforts, in particular, may benefit from tax advantages and incentive programs. These funding sources, however, sometimes have even more stringent requirements than a standard construction loan.
While not usually considered in terms of construction funding, there might also be cases in which an angel investor or venture capitalist can step in to help with a specific project. As you explore possibilities, don't rule anything out. You never know where the right match may be made.