Real Estate Construction Loans and How They Work

Building a home or investment property can be very costly. If you don’t have the cash to finance your new project, you’ll need a construction loan. These loans are designed to provide the funds needed to buy land and pay for construction materials and the labor that goes into building the new property.

What Are Real Estate Construction Loans?

Construction loans or home-building loans are short-term loans that provide the funds needed to build a new property. They are typically for less than one year, and the funds are paid in a series of installments. These installments are commonly known as “draws” and will be provided to the developer as the new property is being built. Construction loans are also used for developers to cover the costs of the project before obtaining a large, more secure, long-term funding source. A private construction loan is typically riskier than conventional loans, so it is more expensive.

How Do Construction Loans Work?

Construction loans can be taken out both by private home builders (people who want to build their own homes) or by larger real estate developers who need a quick cash solution for their projects. The loans are for a period of one year or even less (for the duration of the project). The borrower can pay off the construction loan after construction is complete in various ways. The loan can either be refinanced into a permanent mortgage or can be refinanced with another loan (called the end loan). Of course, the loan can also be paid off in cash. Some construction finance companies may require the balance to be paid off completely by the time the construction is complete, while others may ask for payments for multiple years, even after the project is completed.

Construction loans that are taken by real estate developers may be paid directly to the contractor. In this case, the actual borrower does not have access to the funds, as they are paid directly to the contractor during the project. Construction loans are available for both new and restoration projects (apartment buildings, commercial buildings, hotels, and other types of new or restoration projects).

What Do You Need to Know About Construction Loans?

Most construction finance companies require a 20 percent down payment on loans (some go for 25 percent, especially your project is smaller). Getting a construction loan can be difficult for clients who have a limited or poor credit history. Also, the collateral is absent in many cases (the property is not yet built), so getting approval may be difficult for some borrowers. Most construction finance companies will ask for numerous project details (known as the blue book) to understand what the project will look like. Also, lenders will require proof that the contractor is qualified to work on the project.

What Do Construction Loans Cover?

A loan for an apartment building covers every expenditure produced by the project. This includes design costs, construction materials, and labor. You’ll have to provide a detailed list of estimated amounts of materials and labor that will go into the project. The funds may also be used to cover the cost of permits, land, framing, interior finishes, and other miscellaneous or unexpected costs.

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