Construction loans are available for financing the construction of both residential and commercial properties. Depending on the purpose for which a builder requires funding, construction loans can be broadly classified into two categories: commercial and residential construction loans.
Commercial Construction Loans
Any real estate that can be used for business is known as a commercial property. Commercial construction loans can be used for constructing commercial property like shopping malls, restaurants, and office buildings. These loans can be used to build a new structure, renovate an already existing building, purchase real estate, or expand an existing structure. Commercial construction loans are provided by commercial banks, credit unions, U.S. Small Business Administration (SBA) and other lending institutions.
Acquisition and Development Loan
This loan is meant to cover the cost of purchasing land and the cost of horizontal improvements that are to be made on the land. Horizontal improvements refer to changes like leveling the land, building roads, building a sewer system, grading the land, and so on. The lending institution does not provide the entire cost of acquiring and developing the land. The builder is generally expected to bear 25% of the cost of acquiring and developing the land.
Mini-perm loans are generally used by the builder before he has access to permanent sources of financing. This is a short-term loan which is used by the builder to establish an operating history which in turn would help him access a long-term permanent loan.
A bridge loan, as the name suggests, helps to bridge the gap between applying for a long-term loan, and the sanctioning of the same by the lending institution. Although, a bridge loan appears similar to a mini-perm loan, the difference is that mini-perm loans are provided by commercial banks, whereas bridge loans are granted by private lenders.
This type of permanent loan can be best understood with the help of an example. Let us assume that a builder is provided a construction loan by a lender for the construction of a residential building. On completion of the project, the buyer of the house is provided a take-out loan by the lender. The builder who now assumes the role of a seller, sells the house/condominium to the buyer, who in turn pays for the house/condominium using the take-out loan. The builder/seller uses the money from the sale of the house/condominium to repay the construction loan.
Construction Interim Loan
These loans are provided during the construction phase for a period of 6 months to 3 years. During the construction period, the builder is expected to make only interest payments on the loan. These loans are subject to obtaining permanent long-term financing. The interest payments are generally floating and there are penalties for prepaying the interest or principal on such loans.
Joint Venture Loan
In case of a joint venture loan, the builder enters into a joint venture with a lender to share the profits and the losses of the project, and obtains the necessary funds for his project.
Real Estate Purchase Loan
These loans are generally meant for the expansion and the improvement of the existing commercial property. In this case, the property acts as a collateral for the loan.
Residential Construction Loans
A construction-only loan is provided for a maximum period of 1 year. During the construction period, the builder pays only interest on the amount of loan. The loan is provided in installments and the interest on each successive installment is greater than the amount of interest that has accrued on the previous installment. At the end of the construction period, the builder/homeowner takes a mortgage on the house and pays off the construction loan. The advantage of a construction-only loan is that the builder/homeowner does not have to obtain the mortgage from the same lender who provided the loan for construction. However, he is forced to incur closing costs associated with, both the construction loan, and the mortgage.
Construction-to-Permanent Mortgage Loan
This loan combines the construction-only loan with a mortgage on the completed house. However, a different rate of interest is charged during the construction period and post construction. In case of a construction-to-permanent mortgage loan, the builder may be forced to pay a penalty, if the construction period exceeds 1 year. The borrower has to bear a single closing cost, but is forced to obtain the construction loan and borrow the amount of the mortgage from the same lender.
Depending on the requirement of the borrower, he can obtain a residential or commercial construction loan. In both cases, the ability to repay will determine the interest that has to be paid on the loan. The feasibility of the project, and the value of the collateral, assumes a great deal of significance in case of commercial construction loans, while in case of residential construction loans, the credit score of the borrower is fundamental to obtaining the loan.