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How do
construction loans work? With a brief overview, we can answer
this general question.
Construction
loans are loans that enable a borrower or borrowing entity to build.
There are a wide variety of construction loans, ranging from
construction loans to build a personal residence, to construction
loans for strip malls, subdivisions and more.
Although there
are a wide variety of construction loan types, they all work in
generally the same way.
The goal of a
construction loan is to enable the project to be fully built.
Typically, at this time, the project will either be financed with
permanent financing, or the construction loan will roll over into a
permanent loan, often called a construction to perm loan.
There are a few
parts that make up a construction loan. When asking "how do
construction loans work", it is important to understand these
separate components.
The first
component is the cost to build the project. This includes all
hard and soft costs, and typically a contingency will be built in.
This is important, as construction can run over budget for a wide
variety of reasons. We always want to ensure that there is
enough money to complete construction.
The funds for
construction, plus contingency, are typically held in a builders
control or a fund control account. These funds are disbursed
to the project on a draw process. There are many different
draw processes, but the general idea is that the money is being
controlled to ensure it is being used for the work on the project,
not a different project. As certain milestones are hit, more
money is made available to continue the construction.
In addition to
money for the actual construction, most construction loans also
carry an interest reserve. This is money that is held in an
escrow account and used to make monthly payments on the loan.
How long of an interest reserve you will need depends on the
project, estimated time of completion and the lender. The goal
is to wrap the expenses associated with the project into the loan,
so that there are no monetary obstacles to completing the project.
Most
construction loans are made based on the as complete value of the
project. With hard money construction loans, you can typically
expect to obtain about 60% of the as complete value as a maximum
loan amount. If that is not enough to cover the construction,
it is likely you will need to bring additional cash to the table to
close.
Another
component of construction loans these days is the amount of cash a
borrower has "hard" into a deal. Regardless of how good the
project is, it is difficult to finance without having some skin in
the game. A good rule of thumb for hard money construction
loans is that you need to have 50% of the cost of the land plus 20%
of the hard and soft costs of the project into the deal in cash.
If you have a
particular project and would like to discuss your construction loan
options, please give us a call. Typically we can let you know
through a brief conversation if your project is one we can
potentially help obtain financing for.
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