A construction loan is a short term financing facility, secured by a mortgage registration against the property where construction is taking place, that is used to pay for the cost of the project as the costs are incurred.
Construction loans, like any other type of loan, require that the borrower provide a certain amount of equity in the project. This can come in the form of equity in the property that is under construction, cash investment in the project costs, or some combination of the two.
The construction loan provides funds via a draw schedule that outlines what amount of work needs to be done before money can be advanced towards the project.
The draws are typically defined at stages of construction when the collective work completed to that point would be viewed to have added value to the property.
Once a construction draw milestone is reached, the work completed is reviewed either by the lender or a third party appraiser to verify that everything is in keeping with the agreed to project plan signed off by both the borrower and lender at the start of the project.
If everything is in order at the time of a draw request, the funds ear marked for the particular draw are advanced to the borrower who in turn uses the funds to pay outstanding bills to suppliers, contractors, and service providers.
For a home construction loan or smaller commercial project, there are typically three draws during the time period when construction takes place.
From a borrower’s point of view, the advance of the first draw is a very important milestone in that until the first draw advance takes place, the construction loan provider does not have a vested interest in the property as all funding to that point has been provided either by the borrower or through arranged trade credit.
Once the first draw is advanced, the construction lender is going to be more concerned with funding the project’s completion as they now have funds into the deal at risk.
Each construction lender will have their own requirements in terms to draw administration and what can or can’t be paid out of the construction funds.
Typically, the construction loan will require debt servicing on a monthly basis as long as the loan is active. Debt servicing requirements can be different from lender to lender, so it will be important to understand not only the cost of debt, but how it will impact the project’s cash flow.
Once the project has been completed and signed off by the proper authorities, the borrower will be required to retire the construction loan in full. This can come from the borrower’s own resources, a long term mortgage if the borrower is retaining the property, or through the proceeds of sale.
Depending on the lender, there may or may not be a requirement for the long term take mortgage to be arranged prior to the start of construction.
A construction loan will be higher priced as compared to a conventional property mortgage due to the risk associated with construction. Once construction is complete, the risk is removed and lower cost forms of mortgage financing are then available for a long term repayment of the construction costs incurred.