What is a Construction Loan?
A construction loan is a unique and complex type of funding. Also called a building loan, construction mortgage, or development loan, a construction loan is a short-term (usually less than three years) loan intended for financing the construction of residential or commercial developments. Construction loans cover the cost of land development and building construction. In this blog, we'll explore how construction loans work and the requirements to secure one.
Construction loans typically have higher interest rates and are secured by the property they finance. These loans are generally paid off with permanent financing using the cash flow generated by the completed building. The money borrowed through a construction loan is disbursed in a series of draws according to a prearranged schedule or milestones.
There are three main steps involved each time loan funds are disbursed:
- Draw request processing and approval. The borrower’s draw request needs to undergo review to provide proof of milestone completion within the selected timeframe and budget. When the capital partner approves the draw request, the project can move into the next stage.
- The disbursement of funds during construction. This happens over course of the project. Funds are released per the details in the schedule of values and the draw schedule. Upon receiving the necessary reports, the bank will send out a third-party inspector with the task of confirming that this particular part of the project is complete. The inspector will then provide a construction inspection report with recommendations that the draw request is funded or revised based on the progress of the project.
- Servicing the loan. This is the administrative process of managing a construction loan. Loan servicing includes collecting interest, managing payments, and keeping payment records.
How to Get a Construction Loan
To be eligible for a construction loan, a borrower needs to have three necessary items in check: the money, a plan, and a contractor.
Winning a construction loan is often a complicated process that requires the borrower to know the right people and create a feasible business case for a proposed development. To get a loan request approved, the borrower needs to win over the trust and confidence of the right construction capital partner. Borrowers need to prove they have the right team, including an experienced general contractor with a record of quality and on-time work. The borrower must create a sound and feasible financial plan based on market dynamics, location, and capital requirements. A capital partner can more easily assess risk and fund the loan with a thoughtful and thorough business case in hand.
How Long Does it Take to Get a Construction Loan?
Typically, the average borrower waits 30 to 60 days for loan processing and approval. If the capital partner has all of the information available and the project’s plans and financial assessments are rock-solid, there should be no need for the approval process to take longer than 60 days.
Other Terms to Know
Borrowers may be asked to sign a construction loan agreement during the process. This is a legally binding contract between the lender and the borrower, detailing the promises and commitments both parties have to uphold through successful project completion. The borrower can expect the standard construction loan agreement to include the following:
- Definition of Terms
- Terms, Conditions, and Procedures for Borrowing
- Representations and Warranties
- Affirmative Covenants
- Negative Covenants
- Events of Default and Remedies
- Assignments
- Lender’s Disclaimers – Borrower’s Indemnities
- Miscellaneous
Another document to know is a construction loan note. This is a short-term obligation used for the funding of construction projects such as housing developments or commercial properties. In most cases, the note-issuers repay the note obligation by issuing a longer-term bond. They then use the proceeds from the bond to pay back the note.
Managing Construction Loans
Construction finance software like Rabbet helps lenders and capital partners mitigate lending risk. Through built-in data validation and better visibility into loan performance, capital partners can more easily make confident lending decisions. Learn more about how Rabbet Construction Finance can streamline your lending operations.
