Construction loans provide businesses with the funds they need to purchase upfront materials, secure equipment, and cover operational costs that arise before, during, and after they complete jobs. They’re generally a short-term solution, although long-term financing options exist for larger projects that require a lengthier term.
Applying for a construction loan can be a complicated process with various nuances, so it’s important to start the process on the right foot with all the information you need to make an educated decision about the future of your business.
Continue reading for everything you need to watch out for as you prepare to secure a construction loan for your business.
What Exactly Is a Construction Loan?
A construction loan is a financing solution designed specifically for construction businesses to help them cover expenses, complete jobs on time, and take advantage of opportunities that arise. You can use the funds for almost any business purpose, including materials, inventory, equipment, payroll, and working capital.
They function just like any other type of business financing. If you secure a term loan, you’re provided a one-time, lump sum payment that you manage throughout the term. Equipment financing and lines of credit are a bit different, but both options provide access to capital for specific circumstances.
Repayment schedules are flexible, with short or long-term options available depending on your needs. Generally, short-term construction loans are used for projects or opportunities that pay off within a year or less, and long-term options are best suited for projects or investments that won’t yield a return immediately.
What Types of Construction Loans Are Available?
There are a few different types of construction loans:
Short-Term Construction Loans
Short-term construction loans are designed to be repaid within one year or less. They typically have higher interest rates compared to long-term loans, and their repayment schedules are much more frequent. In most cases, borrowers repay their loans through weekly or daily payments to their lender. While this might seem overwhelming, it’s a beneficial option for specific circumstances that allow borrowers to escape debt faster.
Long-Term Construction Loans
Long-term construction loans come with repayment schedules of up to 25 years. Compared to short-term loans, they have higher funding amounts, non-intensive repayment schedules, and lower interest rates, although borrowers end up paying more interest than short-term loans because they’re paying interest for much longer. Some long-term loans require collateral, but this will depend on the financial background of your business, the lender you’re working with, and the economic conditions surrounding your transaction.
Construction Lines of Credit
Construction lines of credit aren’t technically loans. Instead, they offer flexible access to capital on an as-needed basis, like a stronger business credit card. Interest applies only to the amount you draw, and if you’ve secured a revolving term, you can draw the same funds again after you’ve repaid them.
They’re a great option for covering consistent expenses and spreading the cost of investments over a more manageable schedule.
Construction Equipment Financing
Equipment financing is a powerful tool for construction companies and contract businesses. Instead of putting pressure on your cash flow with a sizeable purchase, you can break down the cost over time and preserve your liquidity for other opportunities that come your way.
Construction equipment financing can help your business purchase loaders, excavators, skid-steer loaders, trucks, and much more – you can even leverage this option to cover the cost of CRM software and other technology.
How Do I Qualify for a Construction Loan?
You must fulfill all of these requirements to be authorized for a construction loan.
580+ credit score
Your credit score is essentially a snapshot of your credit history. Lenders use it to judge your likelihood of repaying your financing within the specified term, with low FICO scores serving as a red flag of potential default.
Banks and credit unions often want to see 700+ credit scores, whereas most non-bank lenders set 580+ minimums.
$120,000+ in Annual Revenue
Remember that lenders will look over your financial details to confirm your income and assets and ensure you have a solid financial foundation to repay the construction loan. They’ll use your annual revenue as a measure of this, so come prepared with documentation that shows exactly how much you make yearly.
1+ Years in Business
Startups and newer businesses pose a greater financial risk than well-established ones. Lenders know this, so they impose “time in business” minimums to protect themselves from a bad investment.
Some lenders work with startups, but most want to see at least one year of business history.
Thought Out Business Plan
Lenders will view you favorably if your construction project is well-planned, meticulously defined, and properly laid out when you apply. Being realistic with budgets is also crucial in this situation. If you exaggerate the price of specific building procedures, you might find reaching an approval to be a challenge.
Top 5 Costly Mistakes You Must Avoid When Applying for a Construction Loan
You want to access capital quickly and efficiently, so make sure you watch out for these mistakes.
Not Comparing Rates From Different Lenders
When applying for a loan, or any financial product for that matter, it’s always best to shop around. Unfortunately, many borrowers applying for a construction loan tend to skip this critical step.
Naturally, construction companies and builders have their go-to lenders because it’s often convenient to do regular business with the same entity. However, limiting yourself to one option can cause you to miss out on a better deal elsewhere, so it’s important to apply with multiple bank and non-bank lenders to understand exactly what offers are on the table.
That way, you’ll have options to choose from when it’s time to make a final decision. You won’t have to wonder if there was a better offer you could have chosen; You’ll already know you selected the right one.
Underestimating the Project’s Timetable and Cost
Another common mistake that construction loan borrowers tend to make is underestimating how long it would take to complete their project.
Several factors can affect the timeline of your project, from securing your permits to adjusting construction due to the weather. Likewise, changes in the project are unavoidable, even in the middle of the construction.
You must also nail down your budget and get a more accurate cost estimate for your building project. For instance, you must not forget about allocating a budget for contingency. It will give you enough wiggle room in case of sudden changes, such as the cost of materials and even theft or burglary. Ideally, you must set aside 10 to 15% of your total budget for contingency.
Securing Terms That Don’t Fit Your Goals
It’s understandable to want to save on costs whenever possible. However, getting a construction loan with too short a term can turn out to be costlier. If your construction project isn’t finished by the time your loan is already expiring, you will have to pay fees to extend your loan or – even worse – deal with a default situation.
That’s why, as stated in the previous item, you need an accurate estimate of the timeline for your project. Projects tend to take longer than your initial estimate, so it’s recommended that you take a construction loan that’s at least 12 to 18 months, depending on whether you’re building from the ground up or renovating.
Not Negotiating Terms With the Lender
Some borrowers believe that the first contract they receive is the final offer on the table – when that’s usually not the case. Every loan contract has room for negotiation. Whether that be a small change, like an extra few days on repayment, or a major one, like a two-point interest rate drop, it’s important to negotiate with your lender and ensure you’re doing everything you can to reduce and tailor the terms to your business.
For example, borrowers may be able to increase their funding amount by showing the lender that the price of their materials has increased. You’ll have to show evidence that the cost has increased, of course, but this step can be the difference between covering the entire cost of your upcoming project or having to pay for some of it out of your cash flow.
Choosing the Wrong Option for Their Goals
Lastly, borrowers want to ensure they’re choosing the right financing option for what they want to achieve.
Lump sum options, like term loans and revenue-based financing, are best for projects where you know the exact cost, while flexible options, like a business line of credit, are better suited for ongoing capital needs. Many borrowers prefer lines of credit because of the flexibility, but they may qualify for better rates and terms on other financing options.
For example, a construction business looking to cover upfront materials for a project may want a line of credit to handle costs as they arise. However, the interest rate on their credit line is higher than what they would qualify for on a term loan product. If they finalize the line of credit and forgo the term loan, they could wind up paying much more interest than they have to.
As you apply with lenders, you should explore the options you qualify for with each one. Ask about term loans, lines of credit, and any other available options while keeping in mind what you’ll use the funds for specifically.
In Summary
Financing is a powerful tool for construction businesses looking to take on more work, streamline projects, and invest in their operations. With flexible options that you can tailor to your needs, it’s worthwhile for every construction business to explore their options and see what they qualify for.
Still, it’s important to go about the process in a strategic fashion. Do your research, work with the experts, shop around, compare your options, and don’t hesitate to negotiate. These will help you make the most of your money and get the best results for your project.