What is construction finance?

Whether you are working on a home extension, a self-build or a commercial construction project, it can be a challenging task to secure funds. It may not be easy to navigate the world of building loans and construction finance but before you can take any big decisions you must understand what is available and how much it costs. 

In this guide, we will explain how construction finance and building loans work, address common key concerns and provide you with the information that you need about the sector. 

What Is a Building Loan?

As the name suggests, a building loan is a short term loan which can be used for the payment of the construction costs of a building project. A number of different types of builds are covered by building loans. The other names for building loans are self-build loans, construction loans, homeowner loans, home-building loans, and home improvement loans.

Building loans should not be confused with traditional mortgages as both are quite different from each other. The price of mortgages is determined on the basis of a property’s value and also previous sales of similar valued properties. A building loan, however, depends on the cost of the project. Mortgages are loans that offer the required capital as one lump sum whereas a building loan is generally given in instalments according to a pre-agreed schedule.

The term of a building loan is significantly shorter than ordinary home loans and they tend to have higher interest rates than mortgages. It is not uncommon for the term of a building loan to be one year as it must also account for the time taken to build a project.

Some Facts about Building Loans

• The cost of a building project is covered by building loans.
• The value of the finished property doesn’t form the basis on which the loan amount is decided.
• They are mostly short term loans.
• Unlike mortgages or home loans, the loan amount is not provided upfront but paid out in instalments. 
• The different stages of the building process decide when the money instalment is paid to the borrower. 

What is Construction Finance?

Even though building loans fall in the category of construction finance, construction finance is a term which is frequently used to refer to the finance which is used to bridge the gap between work completed and payment for that work.

Flexible finance is a necessity for construction firms. These firms are under constant pressure to build more and more houses as the demand for houses has gone up, but house building hasn’t been able to keep up with the rising demand. This has resulted in the setting of tough targets by ministers to meet the shortfall and the target is to build at least 300,000 new homes by the mid-2020s. 

But issues like extended payment contracts and late payments can hold up not just house building projects, but several other types of infrastructure projects as well. This creates difficulties for companies to pay wages to their workers and meet their construction goals. This is where construction finance steps in to solve their problems. 

How Does Construction Finance Work?

In simple terms, construction finance allows firms to buy the much needed materials, keep cash flowing, pay contractors and hire equipment. For small construction companies it can prove to be life saving. 

Besides the benefits mentioned above, construction loans make it possible for businesses to access significant proportions of the value of outstanding invoices. This practice is known as construction factoring and it makes cash available to businesses without them having to wait for months to get paid. In special cases, it can also be used for partially completed work and payment applications. 

A construction loan can also be considered to be a form of prepayment provided by the lender. Several factors need to be taken into consideration, just like in the case of any other loan, such as credit history and credit score as well as other outstanding debts. 

Some Facts about Construction Finance

• Construction finance is generally used by construction companies to bridge the gap between unfinished work and the payment for that work.
• This type of finance is usually short-term
• It is ideal for construction firms that are dealing with immense pressure to meet their building targets and are looking for flexible funding options. 
• It allows companies to raise funds against outstanding invoices and new applications for payment.
• Construction finance allows companies to hire equipment, keep building, settle wages and pay for materials when cash flow is uneven.

 How Much Do Building Loans Cost?

Like any other type of finance, there are various factors upon which the cost of a building loan depends. It majorly depends on the finances of the company or individual, including their recorded credit history and existing debt. The repayment schedule that you agree to along with the amount of loan that you apply for will influence the interest rate that you will need to pay on the loan amount.  

When such circumstances arise that continuing the construction project seems unlikely, construction loans make it possible for companies and individuals to continue working on the project. One thing that must be remembered is that different construction loans come with different interest rates. Generally, a variable rate needs to be paid by those who want to draw on a construction loan, which means that the rate of interest can rise as well as fall in the future. In most cases, interest needs to be paid on the amount that you borrow and not on the loan balance, making construction loans a type of interest-only loan.

Interest rates are likely to be higher compared to home loans, car loans or any other type of personal loan as the amount borrowed for the purpose of construction is naturally higher, which means it is a greater risk for the lender. A large down payment is a typical requirement when financing new construction.

The ability to access construction finance when it is most needed can mean the difference between a complete and an incomplete project.