What is a construction loan?

Types of business construction loans and financing

Business line of credit

Technically considered revolving credit rather than a loan, a business line of credit is considered a highly flexible financial tool. That's because it offers funding that you can draw against as needed — which is particularly helpful to bridge the gaps during seasonal cycles, gaps in contract payments, or business opportunities.

For example, when Chandra Womack saw an opportunity to expand her business by acquiring a company, she applied for a business line of credit. With a line of credit, she was able to complete the acquisition and pad her cash flow to cover the increased payroll and expenses with the new influx of jobs. With a business line of credit, you only pay interest on the funds you use, compared to a traditional business loan, which charges interest on the total amount borrowed.

Construction mortgage loans

Loans to finance the construction costs of erecting a new building — whether it’s for your business or someone else’s — tend to work a little bit differently than traditional mortgages. Instead of disbursing a lump sum all at once to borrowers, funds get spread out over time, pending regular progress inspections by the lender. Since construction mortgage loans are meant as short-term loans, they tend to carry higher interest rates.

Construction-to-permanent loans (CP loans)

One solution to the problem of short-term construction financing and a long-term mortgage is to blend the two together. A construction-to-permanent loan (CP loan) does exactly that, which can help businesses focused on developing homes that are in need of covering the associated construction costs.

When the project is finished, the debt automatically converts to a mortgage for your business — no extra closing costs, application fees, etc. You can potentially lock in your rate upfront before breaking ground, which can help your bottom line if interest rates climb.

SBA-backed construction loans

Another option is SBA loans, which often offer low interest rates. The SBA offers two types of loans for construction businesses: the Standard 7(a) SBA loan which can be used for a wide range of purposes, and the CDC/504 SBA loan which is geared towards community development — i.e., construction.

The downside is that it can take months to get a decision on an SBA loan application, and approval requirements tend to be very strict.

Traditional commercial construction loans 

When you think of small business loans, you're probably thinking of a loan that's paid out in one big check, with steady, equal monthly payments over the course of months or years until it's paid off. That's exactly what a traditional loan looks like, and it can still come in handy when running a construction business.

Traditional loans are usually best for large, planned purchases rather than day-to-day fluctuations in cash flow for your construction business. They come in two versions: secured or unsecured. Secured loans often cost less since borrowers can use collateral to get lower rates, whereas unsecured loans are usually more expensive. For example, equipment loans are a common type of a secured business loan, like an auto loan you might use for a personal vehicle.

How does a construction loan work?

The process of managing a construction loan starts before you even apply for the loan.First, figure out what you need, and how much. Are you looking to bridge a gap in construction projects, hire on more employees to grow your business further, or invest in equipment that lets you expand your service offering? Your business needs will help dictate which type of funding is best suited for you, and for how much you seek.

Once you know the amount you need and the type of funding, you can shop around for quotes to find the best cost. Make sure the payments are something you can afford in your business's budget before you apply.

After you apply and get approved for construction financing, you'll receive the money according to the terms of your contract. For a business line of credit, you won't receive any money until you make a withdrawal. Some construction loans may disperse the money periodically, pending certain inspections to make sure you’re completing the work on schedule. Traditional loans pay out all at once.

Make sure you understand the terms of your repayment. With some loans — such as CP loans, for example — you might only be making interest-only payments during the construction phase, followed by higher monthly payments once it converts to a mortgage.

Commercial construction loan rates

The rates you'll pay for a commercial construction loan may vary depending on several different factors.

The first major factor is the type of loan you're seeking. If you're looking for a construction line of credit, you may have to pay a higher rate, but you'll only have to pay it when you've drawn against your line of credit.Another major factor is your credit, and how long you expect it to take to repay the debt.

How long are most commercial building loans?

The length of time it takes to repay your debt depends on which type of loan you selected to fund your construction business. Short-term lines of credit can often be repaid in six months or less. Commercial mortgages, on the other hand, are commonly repaid over five to 20 years.

Small business financing products can make a world of difference when taking your construction firm to the next level. Here are some examples of different ways you can use your funding:

• Hiring and training new employees

• Constructing a new front office, stockyard, or shopInvesting in new marketing materials and professional websites

• Keeping enough working capital on hand to manage short-term business needs

• Purchasing equipment or materials that let you bid on higher-ROI construction projects

• Smoothing out construction company cash flow from seasonal ups and downs or gaps between contracts
  

How to get financing for construction companies?