Running a construction business can be capital intensive. You have to purchase and repair equipment, hire employees to scale, and market your services to get customers amongst a myriad of other related issues which all require consistent cash flow in order to succeed. While self-financing, is certainly the best overall option when it comes to funding your construction company or projects, for many it simply isn’t a possibility. This is why many people turn to financing options to help launch their business, or to fund a new venture within an already-established company, such as purchasing new equipment or expanding departments. If you’re a business owner in the construction industry, it’s not really a question of “if” you will eventually want access to capital for financing your business it’s a question of “when.”
A construction loan is a type of short-term financing, created for the specific purpose of financing a new home or other real estate project. The loan can be applied for by anyone who is investing their time and money in construction or related expenses. An individual homeowner or a contractor can use construction loans to finance their construction project. Not just only for the actual building, a construction loan can also be used to pay for building equipment used in construction, building materials, or for hiring employees. In this post we’ll discuss how construction loans work, the types of construction loans available, as well as the Pros and Cons.
How Exactly Does This Loan Business work?
A construction loan is a type of bank-issued short-term financing, created for the specific purpose of financing a new home or other real estate project as stated earlier. They are based on what the projected value of the home will be once the work is completed. Construction loans are typically short term with a maximum of one year and have variable rates that move up and down with the prime rate. To gain approval, the lender will need to see a construction timetable, detailed plans, and a realistic budget, sometimes called the “story” behind the loan. Once approved, the borrower will be put on a bank overdraft or draw schedule that follows the project’s construction stages and will typically be expected to make only interest payments during construction even as the lender will follow physical progress.
Best Construction Loans for Your Building Company
- Equipment Financing- Obtaining equipment is one of the most common reasons small business owners seek outside financing. Equipment financing is the use of a loan or lease to purchase or borrow hard assets for your business. This type of financing might be used to purchase or borrow any physical asset such as a tower cranes or trailers. Another option is the lenders leasing out expensive equipment, from cement trucks to bulldozers, and the recipients pay as they go. There is an enormous number of variations on equipment financing that cater to specific types of businesses and equipment. Here your lender fronts you up to 100% of the cash you need to purchase the equipment, and the equipment itself functions as collateral in case you default on your loan. It is easier for new construction companies to qualify for secured loans than unsecured.
- Financial Lending for Startups- Third parties exist now in addition to more traditional vendors to help finance your business. One of the positive aspects of this option is the speed at which you can get approved and gain access to your funds. In some instances, you can finish the process in as little as a couple days, making it a convenient way to cover weekly payroll costs or unexpected expenses. Some potential downsides to this option are needing excellent credit to get approved for the loans, as well as the interest rates attached to the funds.
- Investors- Investors are a terrific option for any business owner looking for more than just a blank check. Oftentimes, investors are former construction or field service savants who were successful in the industry—making them a great resource for mentorship or guidance when it comes to business decisions. However, one of the cons of this choice, obviously, is that it can be difficult to get in touch with investors and land their funds. On top of that, the exchange of money often involves giving up some sort of equity or stake in your company. So, if you want complete ownership of your company, investors wouldn’t be the best route to take. But it definitely is an option that should be considered, especially by developers.
- Bank and SME loans- SME and other bank loans are among the most popular options for financing construction ventures. Given their flexible terms, low interest rates, and wide variety of loan amounts, they’re a particularly solid alternative for entrepreneurs looking to launch a construction business. Best for established construction companies as you can only use SME loans if they suit the SME’s eligible use-cases, like working capital, purchasing equipment, or debt consolidation. click here to see how to draft a loan proposal.
- Business Terms Loans- A traditional business term loan is a lump sum of capital that you pay back with regular repayments at a fixed interest rate. The “term” in “term loan” comes from its set repayment term length, which will typically be one to five years long. These loans are a good choice for those who don’t meet the requirements to qualify for an SME loan. The lump sums of business term loans are generally handed out faster than banks loans as well, so if you’re in a position where you need the money fast, this could be a nice fit. However, be sure to weigh your options before signing the consent line, the interest rates vary far and wide from lender to lender and situation to situation.
What are the benefits of a Construction Loans?
Choosing a construction loan over a home equity line of credit or other privatized loan has a few, distinct benefits. They are:
- They’re interest-only during construction: Since the loan isn’t paid out in full until the new construction is complete, the bank doesn’t ask you to start paying down the principal until then either. During construction, you’ll only be expected to pay lower, interest-only payments on the loan, giving you more time to save.
- They have flexible terms: Though you’ll need to provide the bank with specific plans for your project, construction loans offer much more flexibility in terms of loan terms and guidelines than traditional loans do. To a certain extent, you’ll be able to work your loan terms around your needs for the project.
- The added scrutiny provides structure: Though added scrutiny may not seem like a good thing at first glance, during the building process, it can actually help ensure that your project stays on budget and schedule.
What are the disadvantages of a construction loan?
Like anything, there are also some disadvantages to construction loans. They are:
- They’re harder to qualify for: Since construction loans are so flexible, they often come with higher qualifying standards in terms of credit and down payment.
- They have higher interest rates: Construction loans typically have variable interest rates that correspond to a certain percentage over the prime rate, or the rate that banks give their best customers.
- Shorter-term loans are a risk: Especially if you’re going for a construction-only loan. At the end of the loan term, you need to be able to pay off the loan in full. If you’re going this route, make sure you have a way to pay off the loan, even if your original financing falls through.
Before making decisions about your potential construction loan, we recommend that you consider a wide range of options. Banks, online lenders, brokers, and subcontractors can each help you through the difficult and stressful process of completing your construction project. On the other hand, if you choose the wrong partners, they can add delays and complexity. Before jumping into one option or the other, though, be sure to do your research to see which works best for you and work with your bankers to review the best alternatives..