Are you thinking about building a property from the ground up? If this is your first time working with construction loans, you’re probably wondering, “How do construction loans work?”. Here’s everything you need to know about how construction loans work and the ways you can leverage one in your real estate portfolio.
What is a Construction Loan?
A construction loan is a type of short-term funding that can be used for covering the costs associated with constructing a property. Construction loans cover a variety of costs from drafting plans to taking out permits and paying for labor. Typically, a construction loan’s time span is around one year.
How Do Construction Loans Work?
Generally, short-term loans will have higher interest rates than long-term loans. Your construction loan is paid out in a series of installments called “draws” instead of receiving one lump sum of cash. Depending on the timeline of your construction project, you will receive “draws” at each major step. Construction loans may have both fixed and variable rates, with variable rate loans based on current economic policy. Since construction loans have a short lifespan, it’s important to stay adherent to the project’s intended completion date.
How to Get a Construction Loan
Depending on the lender you choose, there will be different qualifications for getting a construction loan. Here’s some of the most common requirements for short-term construction loans:
Good to Excellent Credit
When applying for most short-term loans, you are required to have good credit. A lack of good credit can hurt you when applying for a construction loan.
One must have sufficient income to cover the costs of a construction loan while trying to acquire one. Since they are short-term loans, the lender wants to make sure you can pay it back on time. Providing sufficient proof of income can help your chances of approval for a construction loan.
A Down Payment
To acquire a construction loan, you will first have to make a down payment towards your loan. The amount may vary, but generally will sit at 20-30%. After that, you will pay back your loan once you have received all your draws.
Before applying for a construction loan, you will need to have a planned-out construction budget. The lender will want to see exactly how much capital your construction project requires before lending you any money.
A Low Debt-to-Income Ratio
Many short-term loans will require you to have a healthy debt-to-income ratio. Your debt to income ratio measures how much debt you must pay off every month compared to your income. A low debt-to-income ratio tells a lender that you don’t have a massive amount of current debt and sufficient ability to repay the loan.
How to Choose a Loan Lender
When you’re looking for the right lender, it can be hard to narrow down the best choices. How do you know if a lender is right for you? To screen out candidates, you should be ready to ask the lender questions. Choosing the right lender means asking the questions that will determine if the offered loan meets your property’s needs. You should aim to ask questions like:
- What types of construction loans do you offer?
- What interest rates are available? Are they fixed or variable?
- Can I use the equity I have in my land toward a down payment?
- How do you pay construction draws?
Just like a lender will want to know if you are a right fit, you should check if a lender is the right fit for you. Asking the right questions can help determine if a lender has the right loan for your project.
RCN Capital offers short-term and long-term financing options for real estate investors. Whether you are looking to fix & flip properties or hold properties for rental income, RCN has flexible options that are suited to your needs. Connect with us today to discuss your next real estate investment.