How to Choose the Right Lender for Your Construction Loan

Choosing a loan for your construction project is one of the most important decisions you'll make during a development project. A construction loan is a long-term agreement with sizable financial implications, and it's essential that you find a reliable partner that will ensure a transparent and stress-free process. Financial terms are the main point of focus, but you must also consider the lender’s reputation and their ability to assist you through the various stages of the construction project.

The "right loan" is the one that best addresses your project’s specific needs. Before you consider different construction loans, first you must assess the finances you'll need to successfully complete the project. After that, it’s all about finding the best deal with a trustworthy lender.

The Changing Landscape

The construction loan landscape has gone through significant changes in recent years. In the aftermath of the housing boom and its eventual collapse in the early 2000s, a combination of new, stricter regulations and a higher degree of caution from lenders caused a significant drop in the overall volume of issued loans.

Banks, especially those with the highest involvement in construction loans traditionally, took a step back and tightened their requirements for loan approvals, enabling non-bank lenders to fill this gap.

While this shift from banks to non-banks has been more visible in mortgage loans, construction loans have also been affected by this trend. From the perspective of the borrower, the choice between a bank or a non-bank lender isn't all that different, however. While non-bank lenders may be a bit more flexible with their terms and requirements, their offers aren’t dramatically different.

Types of Construction Loans

Construction loans are slightly more complicated than traditional mortgage loans. Construction loans are issued for buildings that haven’t yet been built, which requires a different, more hands-on involvement by the lender. The lender will approve your chosen contractor, dictate the timeline for the disbursement of funds, and, in a way, oversee the construction project.

A construction loan is closely connected to a permanent mortgage loan, which is necessary upon the project’s completion. These are a few of the most common types of construction loans.

• Construction-to-permanent (“single close”) loan. This type of loan is an all-in-one solution that converts a short-term construction loan into a permanent mortgage loan once the construction project is complete. It's a popular option since it simplifies the process and doesn't require the borrower to separately apply for a mortgage loan once the construction is done. This saves time, closing costs, and the costs of reapplying. Construction-to-permanent loans are ideal if you have a clear plan of the construction and its costs, and if you're looking for predictable interest rates.
• Standalone (“two-time-close”) construction loan. This short-term loan only covers the construction project but requires the borrower to acquire a separate permanent mortgage loan when the project is complete. Because there are two separate loans, the closing costs are greater, and borrowers go through the application process all over again. Standalone loans let borrowers shop around once to find the best rates for permanent mortgage loans. They also offer the added flexibility of potentially borrowing more in case of upgrades to the construction project.
• Renovation construction loan. These loans allow borrowers to include the costs of major renovations into their mortgage, instead of financing them upon closing. Most commonly, this type of loan is used to buy property in need of significant construction work. The important thing to note is that the loan is based on the value of the property after the renovation is complete, and not in its current state.

What to Look For

Most borrowers find that doing research before speaking to a lender can help with negotiations. A bit of legwork can help you find a better deal.

Construction loans are a bit more complicated in comparison to mortgage loans. Ideally, you will look for a lender with experience in this field who can present you with various options and guide you through the construction process.

Lending policies differ among lenders, with variations in approval requirements, inspection procedures, and draw schedules. Consider which of these policies best suits both you and the contractor.

Lenders can be quite helpful with realistic budget projections; ask different lenders about how they can help you in this department. You may find that policies vary regarding any existing mortgages you hold. This is another aspect to consider and ask questions about if you already have a mortgage on your current home.

Finally, trust goes a long way. If you have a long-standing relationship with a bank, you may consider going with their loan, even if they don’t offer the best rates. You can even use your existing relationship to negotiate a better deal in exchange for your loyalty.

Ultimately, your choice of lender will depend on a variety of factors specific to your project and your financial state. Giving careful consideration to all the aspects of the loan will set you on the right path towards successful, stress-free completion of your construction project.