- June 26, 2021
The Complete Guide to Construction Finance
Construction financing is not that easy. You earn on a staged basis, which means your earnings depend on the completion stage of the project.
While you need a constant cash injection to maintain the regular supply of inputs and materials, including the monthly salary for your laborers, it can be quite challenging to hit the ground running. This is why most construction firms rely on financing options.
What is construction finance?
Construction finance is a type of funding source that allows you to fund your building projects when you do not have enough money.
These short-term financing options can help you take on larger projects. With the help of financing, you can handle multiple projects and make a lot of money.
These financing options are generally suitable when you are planning to start from scratch. If you are looking to finance a building project about to complete, you should look for other alternatives like commercial property finance. They will be more suitable than construction finances.
How does construction finance work?
Construction finance is a short-term loan and hence the repayment period extends over a period of one year. These loans aim at underdeveloped funding property or building structures.
Whether you borrow money from an online loan lender or a banking institution, the loan size will be determined based on the estimated value of the developed property or building that fulfills the purpose of collateral.
These loans are secured loans, which is why they will likely have affordable interest rates. As the construction work completes, the property is sold so you can repay the loan.
When you apply for the construction loan, funds are released in stages, for instance, at the time of completion of foundation and then at the time of completion of framing.
Make sure that you have got to know when the stage is marked as complete so that the money can be disbursed. You can negotiate the disbursal amount for each stage depending on your requirement.
At the time of taking out a construction loan, make sure that you have already calculated the estimated total cost. The interest rates for these loans vary from project to project.
Considering the risk on the lender’s part, they may decide to lend you money up to 70% of the cost of the estimated gross development value.
If you have a very good credit history and a reputed builder, the interest rates for construction loans will be a few points up the lowest rates for secured business loans.
It means the interest rates for construction loans will likely be higher. There are several types of fees that a lender can charge you while processing the loan.
This can surely add up the cost of the debt. It is always suggested that you should look around and research properly, so you choose the most suitable deal.
However, not all direct lenders sign off on such loans. This is because they involve a significant risk on the lender’s part, but you do not need to worry because there are various alternatives.
What are the alternatives for construction finance?
Here are the most dominant alternatives for financing your construction projects.
Asset financing is a great way to fund the construction project that allows you to borrow money against your assets and inventory stated in your balance sheet.
It can help you raise funds as working capital for your business. All your assets, like equipment, will be served as collateral.
In case of a default, the lender can liquidate these assets to recover their money. These loans are ideal if you need money to fund the raw material to complete the construction project.
Advantages of asset financing:
- You can quickly obtain money using your balance sheet assets. The lender will lend you money based on the valuation of your help.
- Fixed payments can help you manage your cash flow more smartly.
- You can leverage fixed interest rates.
Drawbacks of asset financing:
- You can lose your balance sheet assets in case of failure of repayment.
- You may end up borrowing little money due to the undervaluation of your assets.
- It is not effective for long-term purposes.
Long term unsecured loans
If you need a large amount of money for your construction project, you can seek long term unsecured loans. The repayment length of these loans can be up to three to five years, depending on the borrowing amount.
Note that these loans are unsecured, and hence they will carry a high interest rate. However, long term unsecured loans with bad credit ratings can be more expensive than those with a good credit rating.
However, getting approval for these loans is still not that easy. Because of the nature of the loan, it increases the risk on the part of the lender. It is why you should consider seeking secured loans against property.
If the debt is secured against the collateral, it assures the lender that they have some scope to recoup the debt in case of a default.
Benefits of unsecured loans
- You can easily apply for these loans. All you need to do is to put in the application online.
- You do not have to be afraid of losing any of your assets because they are unsecured.
- They are more affordable than construction loans.
Drawbacks of unsecured loans
- The lender will likely disapprove of your loan application in case you have a bad credit rating.
- You will probably end up paying a high amount of money in interest because of a lack of security.
Bridging loans can be an ideal solution for your large construction projects when you do not have sufficient money to get them off the ground, and you are to wait to raise your first invoice.
In other words, you can use these loans to fill the gap before long-term funding can be arranged. These loans are secured loans because of the collateral in the form of equipment, property, or land.
Unlike secured loans, bridging loans can provide you with an instant supply of cash. The entire processing may finish within 48 hours, which is a very short period when it comes to borrowing a large amount of money.
Advantages of bridging loans
- Bridging loans are short-term loans, so they cannot trouble you even in case of slightly tight cash flow.
- These loans are convertible. If you have taken on it to buy property, you can get it converted into a mortgage.
Drawbacks of bridging loans
- A default can attract very high penalties and interest payments. Sometimes they can be more expensive than adverse unsecured loans in case of a default.
- You may lose your collateral if you fail to repay the debt.
Invoice financing is the most convenient way to borrow money against the raised invoices. This is an ideal solution when there is a significant gap like 30, 60, or 90 days to get paid your invoice. In the meantime, it can be very tricky to meet all expenses to keep the ball rolling.
Advantages of invoice financing
- This can allow you to borrow up to 95% of your invoice.
- You can get money quickly, probably the same day.
- Your invoice itself serves as collateral, so you do not need to secure any additional assets.
Drawbacks of invoice financing
- You cannot access the full value of the invoice.
- You will not have control over collection from your clients because the lender will take over.
How to improve your chances for approval
Regardless of the financing option you are considering for your construction project, here is how you can improve your chances of approval:
- Make sure that you have a good credit rating. No lender will sign off on your application in case of a bad credit rating, and if so, you will likely end up paying higher interest.
- You will have to show your steady growth while borrowing money for a construction project. You will have to prove that you can generate enough profits to pay back the loan.
- If you have a poor credit rating, you should arrange a guarantor to mitigate the lender’s risk. This can help you have a loan signed off on.
The final word
There are various ways to fund your construction projects. Before you put in the application, make sure that the funding source suits your needs and budget. If you fail to settle your debt, you will suffer from a substantial financial loss.