Building loans and construction finance explained

Whether you’re working on a commercial construction project, a self-build or home extension, securing funds can be a challenging task. The world of construction finance and building loans isn’t always easy to navigate but it’s important to understand what is available and how much it costs before making any big decisions.

In this article we will explain how building loans and construction finance work, provide you with the information you need, and address key concerns and frequently asked questions about the sector.

What is a building loan?

Typically it's a short-term loan used to pay for the cost of constructing a building project. Building loans cover a number of different types of builds, and definitions vary to such terms as construction loans, self-build loans, home-building loans, homeowner loans, house-building loans, home improvement loans.

Building loans are different from traditional mortgages, which are based on a property’s value and its price in relationship to similar sales. In the case of a building loan, the total sum is dependent on the cost of the build. Unlike mortgages which are given in the form of a one-off lump sum, a building loan is typically paid out in instalments on a pre-agreed schedule. This is known as ‘draws’.

As previously mentioned, building loans are shorter in duration than ordinary homeloans and they can incur higher interest rates. A year-long contract is not uncommon as the term must allow for adequate building time.

Quick-fire facts about building loans

• Building loans cover the cost of a building project.
• The amount loaned is not based on the value of the finished property.
• Auction finance is another short term funding option to secure property. So is a commercial mortgage but this is a long term funding option.
• Rather than providing all the money up front, the lender pays out in instalments.
• The payment schedule – draws – is determined by the different stages of the building process.

Putting a business loan to work

What is construction finance?

While building loans come under the general umbrella of construction finance, the term ‘construction finance’ is more frequently used to refer to funds used to plug the gap between work completed and payment for that work.

For construction firms, flexible finance is vital. With housebuilding across the UK failing to keep up with demand, the pressure to build enough homes for purpose is constantly under pressure. To meet the shortfall, ministers have set the housing industry a tough target of building 300,000 new homes by the mid-2020s.

But issues like late payments and extended payment contracts can hold up housebuilding, as well as other infrastructure projects, and cause difficulties for companies with goals to meet and wages to pay. This is where construction finance can come in.

How does construction finance work?

Put simply, construction finance helps to keep cash flowing and allows firms to purchase much-needed materials, hire equipment and pay contractors. It is particularly important for small construction companies.

Among other things, construction loans allow businesses to access significant proportions of the value of outstanding invoices, sometimes as soon as they have been sent out. Known as construction factoring, it means that cash is available quickly without having to wait months for payment. In some instances, it can also be used for payment applications and partially completed work.

In essence, the lender is providing a prepayment – a construction loan. Of course, as with other loans, a number of factors are taken into account, including credit score and credit history as well as other debts.

Quick-fire facts about construction finance

• In general, construction finance is used to bridge the gap between ongoing work and the payment for that work.
• This kind of finance tends to be short-term.
• Construction finance is a crucial element of flexible funding for construction firms under pressure to meet building targets.
• It allows firms to raise funds against new applications for payment and outstanding invoices.
• Construction finance helps companies to keep building, hire equipment, pay for materials and settle wage bills.

Construction finance can be used to pay workers when cash flow is uneven

How much do building loans cost?

The cost of building loans varies – much depends on the finances of the individual or company, including their existing debt and recorded credit history. The requested loan amount will also have a bearing on the interest rate as will the agreed repayment schedule.

Construction loans make it possible to build when circumstances might otherwise prevent it. But it’s important to consider construction loan interest rates. If you want to draw on your construction loan, you will probably be paying a variable rate – so that rate can go up or down. In lots of cases, construction loans are interest-only loans, meaning interest is paid on the borrowed amount and not on the loan balance.

When financing new construction, a large down payment is also a typical requirement. As there is more risk with a construction loan than a standard homeloan, interest rates are likely to be higher. Within the construction finance sector, the type of loan will determine cost. A small business loan works differently to a building loan even if they can serve the same purpose: construction.

Frequently asked questions about house-building loans

Do I need a deposit for a house-building loan?

Almost certainly. Lenders usually ask for between 20% and 25%.

Am I eligible for a building loan?

There are often stringent requirements for a construction loan approval. Before approaching a lender, you’ll probably want to ensure that you’ve hired a qualified builder, put together a detailed plan for the build, and have good credit.

How much can I borrow on a construction loan?

This depends. Construction and building loans are supposed to cover the cost of the build so amounts borrowed vary dramatically depending on the project.

The lender will want all kinds of information from you before deciding how much to pay out so it’s important to be realistic – and honest.

How long will it take me to get my loan?

Again, this varies. But if you have all your ducks in a row, the process can be very quick and, in some instances, completed online.

What is the typical length of the contract?

On average, building loans are short-term, usually around a year.

What are ‘draws’?

Construction finance (as opposed to straightforward business loans) includes a schedule of draws. These are payment dates spread out across the build which coincide with important events in the process such as foundations being laid and waterproofing the property.

Can I take out a building loan for home renovations?

Yes. Although there are lots of loan options for something of this nature so it pays to shop around. Do your homework in order to ensure that you get the best deal.