The nuances of construction loans for residential developers

On Behalf of | Jan 30, 2025 | real estate banking & finance | 0 comments

Construction loans are a common way to finance residential development projects. However, these loans work differently from traditional mortgages. Developers must understand the specific requirements, terms, and processes involved to avoid delays and unexpected costs. 

How construction loans work

Construction loans provide short-term funding to cover the costs of building a property. Unlike standard home loans, the lender does not fully disburse these funds at once. Instead, lenders release the money in stages, known as “draws,” as construction progresses. Lenders typically inspect the project before each draw to ensure it meets the agreed-upon milestones.

Construction loans have greater risk, so they tend to have higher interest rates than traditional mortgages. For example, an FDIC paper highlights the potential for weather delays, errors in cost estimations, and greater cost sensitivity to real estate cycles. 

The loans also require borrowers to provide detailed construction plans and budgets. The typical term is one year, and developers are expected to either refinance into a long-term loan or sell the property after construction.

Key factors to consider

Before applying for a construction loan, lenders usually require a strong credit profile and a significant down payment. This initial payment often ranges from 20% to 30% of the project’s total cost. A clear and detailed construction timeline and budget are also necessary. Lenders rely on these documents to evaluate the project’s feasibility.

Interest rates on construction loans are typically variable, meaning they can fluctuate over time. Developers need to factor this variability into cost planning to avoid financial strain if rates increase. Additionally, unexpected delays or cost overruns can impact the loan terms or lead to additional expenses, so maintaining a contingency fund is wise.

Appreciating the unique aspects of construction loans can save developers time and money while minimizing risks. Taking the time to prepare thoroughly can set your development up for success.