If you’re building your own real estate, maybe your dream home, you’ll need a construction loan – a short term loan to pay for the building of the house.
More often than not, these are offered for a set term (typically over a year) to leave enough time for the property to be built. Once construction has finished, you’ll need what is sometimes called an ‘end loan’ which is a new loan to pay off your initial construction loan. This is a more conventional loan for a house, like a mortgage.
So why can it be difficult to get a construction loan?
The main reason is the risk involved for your bank. There is a large degree of uncertainty as the bank is lending money based on a property assuming that it will have a certain value on completion. There are many factors that can change this, such as if property values dip, or the work carried out is not of a good standard, and in these cases, the bank will have made a bad investment as the loan exceeds the value of the property.
For this reason, construction loans usually hold higher interest rates than a traditional mortgage.
The qualifying requirements are therefore quite strict to protect the bank – usually including the below:
- The builder is qualified
They will require you to use a licensed contractor with an established reputation. If you plan on acting as your own general contractor or are in an owner and builder situation, it could be hard to persuade the bank to finance your project.
- You need to provide detailed plans to the lender
This can include anything from information around the materials you’re using, floor plans, and the height of the ceilings, to the type of insulation you’ll be using in the property.
- An appraiser must estimate the value of the building
It can be difficult to estimate a figure as it doesn’t exist yet – but the lender will need an appraiser to do this based on the building specifications and the value of the land you are building on. Often, they’ll compare their calculations with comparable buildings around the same area with similar features, and size, and then adjust this figure.
- A sizeable down payment
You are likely to need a minimum of 20% for a construction loan – in some cases even 25%. This is to show that you are really invested in the project and if things go wrong, you won’t just walk away. It also acts as protection for the lender or bank in case the building is worth less than the estimated value.
By meeting these criteria and, of course, having a good credit rating, you should be able to qualify for a construction loan. They’ll also usually require verification of your income, as you would need for any type of mortgage, to assess whether you’ll be able to afford the repayments.
How do construction loans work?
When the construction loan has been approved, the lender starts to pay out the money as per the loan agreement. Rather than an up-front payment, this is done at intervals called draws.
Throughout the duration of the build, there are usually several draws. As an example, the lender may pay 10% when the loan closes to the builder, the next 10% when the foundation is set, the next portion of funds when the house is framed, and the final amount when the house has been sealed up.
The number of draws and payments included in each loan is agreed by the bank, builder and the buyer. Standard protocol is that the first draw is funded by the buyer’s down payment – that way the risk is with the buyer and not the lender. The bank might also organise an inspection before each draw to ensure everything is on track, and will then pay out the draw.
What are financers looking for in a construction loan application?
First things first – some experience. You need to show you understand the costs and that you’ll be able to maintain control throughout the project. Developers lacking experience usually underestimate the costs involved when planning. Proposals can be complex if you’ve not put one together before, so a lot of financers won’t even consider direct applications without proof that you have thought all these factors through.
The two loan options
1. Bridging finance
This is a short term loan to bridge a gap when it comes to funding. Funders of bridging loans typically don’t require a property portfolio. But they still require a properly packed proposal. They generally will provide construction finance of around 65% of the property’s value. The loan periods vary from one month to three years, and, depending on circumstances and the nature of your project, you can have access to the funding within a few weeks.
2. Joint venture
If you join forces with a more experienced developer, you are more likely to be able to secure funding and have a successful project. This can be provided for 24 months, and you have the benefit of the know-how of someone who has done a similar project before. In this situation, financers will generally provide between £150,000 and £2,000,000, or up to 50% of the gross development value (or what the project will be worth once completed), all the building costs, or a contribution towards the purchase price.
What are the disadvantages?
- The property may not be completed on time or within the allotted budget. If the work takes longer than anticipated, a fee might need to be paid to extend the loan.
- The construction costs may exceed the value of the finished building. This could be because the market falls or the builder is not up to scratch. If this happens, you would need to find extra capital yourself to refinance the construction loan into an end loan.
- Non-eligibility. If your income or credit score changes during the time of the project, you might have your end loan application declined. Construction loans are not supposed to be permanent so this could create a problem. If you aren’t able to pay the balance by refinancing, and the lender refuses a loan extension, they could assume ownership of the building.
Conclusion
Banks can be quite cautious of issuing construction loans, so it’s definitely worth doing your research before applying for a construction loan.
