What is a Construction Loan?

What is a construction loan? That’s a beefy question with lots of variables. In this post, we’ll provide a big picture view of construction lending based on the questions we frequently encounter.

Let’s start with a definition.

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.

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 advances or draws according to a prearranged schedule or milestones.

Loans Concept. Word on Folder Register of Card Index. Selective Focus.

But, how does a construction loan work, you ask? What’s the disbursement process like for lenders and borrowers?

Construction loan payment disbursements work pretty much the same for any construction project, typically depicted by three main stages:

  1. Draw request processing and approval – the borrower’s draw request needs to undergo rigorous scrutiny to provide proof of milestone completion per the loan terms and construction plan, within the selected timeframe and budget. When the lender approves the draw request, the project can move into the next stage.
  2. The disbursement of funds during construction – the construction loan is disbursed over the course of the project, reimbursing the costs of every milestone. The funds are released per the details in the Schedule of Values and the Draw Schedule. The bank will, upon receiving the necessary reports, send out a 3rd-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.
  3. Servicing or the act of collecting interest on the loan

RelatedWhat to review in third-party inspection reports

What are the requirements for 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.

Money – the borrower will have to invest a minimum of 20% total construction capital, provided they show a good credit record.

The Plan – this is the borrower’s detailed explanation of what they want to build and where.

The Contractor – detailing the team or individual who will execute said plan.

The lender will need to check if the borrower has the capital for an equity contribution, whether or not the plan is viable legally and financially, and if a trusted and reputable contractor is on board.

Related: What are the requirements for a construction loan?

How do you get a construction loan?

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 loan manager. To build trust, the borrower will first need to pull together the right team including an experienced general contractor with a record of quality and on-time work as well as a healthy financial position. The general contractor helps build a construction timetable, budget, and detailed plans. Also, the borrower must create a sound and feasible financial plan based on the market dynamics, location, and capital requirements.

A lender 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 would wait weeks for their loan request to be processed and approved, somewhere between 30 and 60 days depending on the borrower’s ability to supply the lender with the necessary documentation promptly. If the lender has all of the information available and the project’s plans and financial assessments are rock-solid, then there should be no need for the appraisal process to take longer than 60 days.

Related: How Do Construction Loans Work

What is a construction loan agreement?

A construction loan agreement 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:

1. Definition of Terms
2. Terms, Conditions, and Procedures for Borrowing
3. Representations and Warranties
4. Affirmative Covenants
5. Negative Covenants
6. Events of Default and Remedies
7. Assignments
8. Lender’s Disclaimers – Borrower’s Indemnities
9. Miscellaneous

Source: SEC.gov

What is a construction loan note?

A construction loan note 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.

What is the interest rate on a commercial loan?

As of this writing, U.S. interest rates on a conventional commercial loan range between 5% to 7%. The construction to permanent loan rates are calculated based on the current market rate you qualify for, plus a .75% increase in case market rates have increased at the end of construction. It’s worth your time to shop around to find the best construction lenders to secure the most cost-effective terms.

About Rabbet

Rabbet provides process automation software to mitigate risk in construction loans. By reading documents, coordinating approvals, and tracking payments, our software creates efficiencies and identifies opportunities to limit exposure for construction lenders and borrowers. Built in Austin, Rabbet’s award-winning software cuts days from the construction back-office operations while ensuring compliance and reduced liability for everyone involved.  Get started with a live demo today or check out our overview video.