What Are Construction Loans and How Do They Work?

A construction loan is a short-term loan aimed at financing a construction project of a residential or a commercial building and major renovation. They are later replaced by long-term mortgages. Construction loans are usually popular among realtors and developers who invest in dilapidated buildings with an ambition to develop a new building. They are highly risky as they carry higher interest rates than traditional mortgages.

While refinancing the construction loan in a mortgage is an option, most borrowers take out a separate mortgage to pay it off after the completion of the project. A construction loan could be used to cover the cost of land, labour, building material, and permits.

How construction loans work

As you know, a construction loan is a short-term loan; they are entitled to be paid back as soon as the project finishes. You will be able to either refinance it into a mortgage or take out a new mortgage to pay it off. However, there is a possibility of taking out a construction loan automatically converted into a mortgage. It is called a construction-to-permanent loan.

Construction loans require interest-only payments while the project is underway. When the project is complete, you will be required to make the balloon payment in fell one swoop or convert it into a mortgage. However, not all lenders will expect you to make payments during the construction.

It is hard to estimate how much amount of money you would need to complete the construction, so no lender would be able to lend the money in a lump sum. They release funds in stages. For instance, once the first storey is completed, then funds for the second storey will be released. Lenders would not require you to pay interest on the borrowed sum, but it will keep accruing over a period of time. Once the project comes to fruition, it will automatically be converted into a mortgage, and you will have to start making monthly payments.

Construction loans are available from banks and direct lenders. A construction loan in the UK could be availed of at lower interest rates if your relationships with your banks are good and your credit rating is up to scratch. As banks tend to be more familiar with the construction market, chances are you will be able to qualify for better construction loans.

Bear in mind that you will need to make a deposit worth at least 20% of the estimated construction loan. However, some lenders might ask you to pay down up to 25%. In the case of a poor credit rating, this could be even higher, and you will end up with high interest rates. Most of the banks and online lenders usually feel indisposed to approbate your application when your credit history is thin and abysmal.

At the time of taking out a construction loan, make sure that you meet the approval criteria of the lender. They will also require you to submit a construction plan. Make sure that there is professional involvement.

If your credit rating is not so good, it is always recommended that you consider using a business loan broker. As they are whole market brokers, they would help you choose a lender that suits your requirements.

What does the application process include?

Here is what you will need to apply for a construction loan:

• First off, you will need to estimate the cost of the construction project. All these details will be shared with a lender as they serve as the basis for the decision-making. Make sure that you receive a preapproval letter from different lenders.
• After creating a detailed construction plan, you will have to create a budget. As you are required to pay down some money upfront, you must have some money stashed away.
• After receiving prequalifying letters, compare interest rates and fees. Choose a lender that offers you money at favourable terms and conditions. After picking a lender, you will need to apply for these loans formally. Your lender will require financial documents such as your income sources.
• The application may take a couple of days to process. Remember that your credit report will also be perused. The lender will then offer you the quote in the loan agreement.
• You are supposed to sign the agreement. The agreement will also clearly explain the repayment terms. After signing the agreement, you will be bound to repay the debt as agreed.
• After the completion of the construction, the loan will be converted into a mortgage. Then, you will start making payments regularly.

What do you need to apply for a construction loan?

Here are the requirements you need to meet to apply for a construction loan:

• You will need to have a decent credit score. No lender would feel disposed to lend you money with a bad credit history. If any lender approbates, they will charge very high interest rates.
• A down payment is mandatory. You will have to pay down at least 20% of the construction loan as an upfront payment. In some cases, it could be more than that. Bad credit construction loans require larger upfront payments.
• You will need pay slips, income and loss statements, tax returns, and bank statements to prove your repaying capacity.
• A detailed construction plan that discusses timelines, permits, and the like is a must.
• Even if your credit rating is stellar, no lender would want you to have a high debt-to-income ratio. It should not be more than 30%. The lower, the better.

To sum up

Construction loans are small loans that are very expensive. Whether you need to construct a building from scratch or you need to carry out a major renovation project, you should always carefully assess your repaying capacity. These loans are converted into mortgages as a construction project is finished. They are more expensive than traditional mortgages. Caution is enjoined so you do not fall into an abyss of debt.