Construction loan
Encyclopedia
In the broadest sense of the term, a Construction
Loan is any loan
where the proceeds are used to finance construction
of some kind. In the United States Financial Services industry however, the term is used to describe a genre of loans designed for construction and containing features such as interest reserves, where repayment ability may be based on something that can only occur when the project is built. Thus the defining features of these loans are special monitoring and guidelines above normal loan guidelines to ensure that the project is completed so that repayment can begin to take place.
, but other terminology may apply in other English-speaking countries. In the United Kingdom
, such a loan would be called a "self-build mortgage". These can also be referred to as Value Added Loans.
of construction loans usually focuses on how that might occur.
In the most basic situation, that of an individual building a home for themselves, a business building a property for business use, or an investor building a property to rent out, the fundamental guideline is for the lender to imagine once the loan has been fully extended and converted into a normal mortgage
and the building is occupied, whether the individual, business, or investor can afford to pay back the loan on a monthly basis. In the case of the individual, where the lender attempts to predict whether the individual can pay each month the loan payment that would occur once the person moves into the house, the lender would be primarily looking at the amount of income the individual receives. In the case of the business, a similar analysis would occur. In the case of an investor building rental property, a special appraisal would be ordered which would attempt to predict what the rents will be and whether they will be enough to pay back the loan, plus all expenses and still give the renter a certain minimum amount of income. The key point here is that no matter how valuable the building might be once completed, almost no lender would extend a loan for more than what the occupier could afford, because even though they will not have to make any payments during construction they would have to make monthly payments once completed and there can be no assurance that the owner would pay down the loan enough to make the monthly payments affordable once the project is completed.
Beyond this guideline, the next most common rule is a minimum cash injection requirement. Even if, for example, a business might be able to afford a monthly payment of a loan high enough to pay for the entire construction project, many lenders would require them to instead use a certain minimum portion of their own cash to complete the project. The reason for this is both to psychologically and economically tie in the owner with the project (hopefully making it less likely that they would walk away from the project if something goes wrong), and to give the lender a cushion whereby if something goes wrong they are more likely to be able to sell the real estate at a value that would better cover the loan amount. This guideline is often termed a "loan to cost" requirement, i.e. the lender will only loan up to 85% of the project costs.
The final major guideline is the maximum loan amount the lender will allow relative to the completed value of the project. This rule is designed to help ensure that, after the project is completed, if the borrower stops paying the payment, the lender can sell the property and hopefully recoup all the funds loaned.
Construction Loans are often extended for developers
who are seeking to build something but sell it immediately after building it. In this case, a special appraisal
is ordered to attempt to predict the future sales value of the project. The first guideline above, affordability, is usually not used because the owner would immediately attempt to sell the property. However, it is used sometimes for example when a developer is building condominiums, the lender might evaluate whether if the project was changed from condominiums to apartments if the rents received would more than repay the loan each month. Cash injection requirements are often higher due to the added risk (the immediate need to sell). The loan to value requirements however are often the most impactful. This is because the value is often calculated differently then how people might assume. For example, if a developer is building a 20 unit condominium project, a lender might not just loan a certain percentage of the predicted future total value of the condominiums, but only a certain percentage of the value of the condominium project if, because of an emergency or unforeseen circumstance, the entire building had to be sold at once to one buyer (known as a bulk sale). Since the realizable sales price in this case might be much lower, the maximum loan many lenders would extend would be much lower.
to pay material suppliers and contractors. Each lender has different requirements for processing a draw. For example, some allow the borrower to request draws online, while others require paperwork and periodic inspections. This process helps ensure that the loan proceeds are actually used for the construction and that the construction process is moving smoothly. The borrower is only charged interest on the amount borrowed at any one point.
Instead of paying each month during construction, almost all construction loans in the United States have extra funds borrowed right away and stored in a locked account known as an "interest reserve". Each month the monthly payments are taken from the account so that the borrower does not have to start paying out of pocket until the project is completed.
.
Construction
In the fields of architecture and civil engineering, construction is a process that consists of the building or assembling of infrastructure. Far from being a single activity, large scale construction is a feat of human multitasking...
Loan is any loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
where the proceeds are used to finance construction
Construction
In the fields of architecture and civil engineering, construction is a process that consists of the building or assembling of infrastructure. Far from being a single activity, large scale construction is a feat of human multitasking...
of some kind. In the United States Financial Services industry however, the term is used to describe a genre of loans designed for construction and containing features such as interest reserves, where repayment ability may be based on something that can only occur when the project is built. Thus the defining features of these loans are special monitoring and guidelines above normal loan guidelines to ensure that the project is completed so that repayment can begin to take place.
Variation in terminology
The term "home construction loan" is the current in the United StatesUnited States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, but other terminology may apply in other English-speaking countries. In the United Kingdom
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
, such a loan would be called a "self-build mortgage". These can also be referred to as Value Added Loans.
Underwriting of loans
Almost all lenders are concerned that their money lent is repaid, so underwritingUnderwriting
Underwriting refers to the process that a large financial service provider uses to assess the eligibility of a customer to receive their products . The name derives from the Lloyd's of London insurance market...
of construction loans usually focuses on how that might occur.
In the most basic situation, that of an individual building a home for themselves, a business building a property for business use, or an investor building a property to rent out, the fundamental guideline is for the lender to imagine once the loan has been fully extended and converted into a normal mortgage
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
and the building is occupied, whether the individual, business, or investor can afford to pay back the loan on a monthly basis. In the case of the individual, where the lender attempts to predict whether the individual can pay each month the loan payment that would occur once the person moves into the house, the lender would be primarily looking at the amount of income the individual receives. In the case of the business, a similar analysis would occur. In the case of an investor building rental property, a special appraisal would be ordered which would attempt to predict what the rents will be and whether they will be enough to pay back the loan, plus all expenses and still give the renter a certain minimum amount of income. The key point here is that no matter how valuable the building might be once completed, almost no lender would extend a loan for more than what the occupier could afford, because even though they will not have to make any payments during construction they would have to make monthly payments once completed and there can be no assurance that the owner would pay down the loan enough to make the monthly payments affordable once the project is completed.
Beyond this guideline, the next most common rule is a minimum cash injection requirement. Even if, for example, a business might be able to afford a monthly payment of a loan high enough to pay for the entire construction project, many lenders would require them to instead use a certain minimum portion of their own cash to complete the project. The reason for this is both to psychologically and economically tie in the owner with the project (hopefully making it less likely that they would walk away from the project if something goes wrong), and to give the lender a cushion whereby if something goes wrong they are more likely to be able to sell the real estate at a value that would better cover the loan amount. This guideline is often termed a "loan to cost" requirement, i.e. the lender will only loan up to 85% of the project costs.
The final major guideline is the maximum loan amount the lender will allow relative to the completed value of the project. This rule is designed to help ensure that, after the project is completed, if the borrower stops paying the payment, the lender can sell the property and hopefully recoup all the funds loaned.
Construction Loans are often extended for developers
Real estate development
Real estate development, or Property Development, is a multifaceted business, encompassing activities that range from the renovation and re-lease of existing buildings to the purchase of raw land and the sale of improved land or parcels to others...
who are seeking to build something but sell it immediately after building it. In this case, a special appraisal
Real estate appraisal
Real estate appraisal, property valuation or land valuation is the process of valuing real property. The value usually sought is the property's Market Value. Appraisals are needed because compared to, say, corporate stock, real estate transactions occur very infrequently...
is ordered to attempt to predict the future sales value of the project. The first guideline above, affordability, is usually not used because the owner would immediately attempt to sell the property. However, it is used sometimes for example when a developer is building condominiums, the lender might evaluate whether if the project was changed from condominiums to apartments if the rents received would more than repay the loan each month. Cash injection requirements are often higher due to the added risk (the immediate need to sell). The loan to value requirements however are often the most impactful. This is because the value is often calculated differently then how people might assume. For example, if a developer is building a 20 unit condominium project, a lender might not just loan a certain percentage of the predicted future total value of the condominiums, but only a certain percentage of the value of the condominium project if, because of an emergency or unforeseen circumstance, the entire building had to be sold at once to one buyer (known as a bulk sale). Since the realizable sales price in this case might be much lower, the maximum loan many lenders would extend would be much lower.
Usual arrangements
Funds are taken from the loan through a process referred to as a "draw". A draw is the method by which funds are taken from the construction budgetBudget
A budget is a financial plan and a list of all planned expenses and revenues. It is a plan for saving, borrowing and spending. A budget is an important concept in microeconomics, which uses a budget line to illustrate the trade-offs between two or more goods...
to pay material suppliers and contractors. Each lender has different requirements for processing a draw. For example, some allow the borrower to request draws online, while others require paperwork and periodic inspections. This process helps ensure that the loan proceeds are actually used for the construction and that the construction process is moving smoothly. The borrower is only charged interest on the amount borrowed at any one point.
Instead of paying each month during construction, almost all construction loans in the United States have extra funds borrowed right away and stored in a locked account known as an "interest reserve". Each month the monthly payments are taken from the account so that the borrower does not have to start paying out of pocket until the project is completed.
Construction Management
Besides the underwriting guidelines detailed above, most lenders attempt to mitigate their risk in a variety of ways. The first involves due diligence on the general contractor, architect, soil upon which the property is to be built, environmental inspections, and appraisals. Then, while the construction process is ongoing, the lenders carefully inspect progress both to ensure construction is proceeding smoothly, as well as to ensure that all workers are being paid so that the security of the loan by the real estate is not violated by a mechanics lienMechanics lien
A mechanic's lien is a security interest in the title to property for the benefit of those who have supplied labor or materials that improve the property. The lien exists for both real property and personal property. In the realm of real property, it is called by various names, including,...
.