Construction finance can be very complicated for the average contractor, but it is critical to understand it to be successful in the construction industry. So, in this piece we’re going to go over the most important things about construction finance every contractor needs to know. Let’s dive in.
What Is Construction Finance?
Essentially, the investment of money into a construction company can come from bank financing, or corporate financing.
Bank financing is simply borrowing money from the bank in order to cover the costs for a construction project. Here are the financing terms you need to know:
- Principal: the total amount of money borrowed
- Term: the due date for the loan to be repaid
- Rate: the rate of interest on the principal
- Maturity Value: total amount of money due at end of the term loan
- Single Payment Loan: the loan racks up interest and is paid in one single payment at the end of the term
- Ordinary Interest Loan: the traditional interest rate system. For example, $10,000 borrowed at 12% ordinary interest would earn $1,200 in 1 year.
- Compound Interest Loan: an interest compounding system that adds interest by month instead of year. So $10,000 borrowed at 12% interest would become $10,098.63 after 1 month (10,000 x 12% x 30/365). And then it would be the same formula except with the new number. This way the interest compounds exponentially.
- Discount Loan: type of loan where the amount repaid is less than principal amount. For example, a $10,000 loan at a 12% discounted basis will end up being $8,800 given to the borrower, with the $1,200 being the discount.
- Installment Loan: the loan on which monthly payments are made even though interest is computed as though the entire principal is outstanding for the term of the loan.
Corporate financing is another way to finance a business; it’s when you create your construction company as a corporation and invest money into it in exchange for common or preferred stock.
How Does Financing Work for Construction Projects?
Let me paint a scenario. You want to build a home, so you check out lots and find the perfect one for your property, and now you need to go to the bank to try to get an ordinary interest loan (see above) to start building it.
In order for you to submit your application you need to submit a schematic set of drawings and estimated budget, preferably by your licensed general contractor or a construction estimating company.
Once the bank approves for your loan, you’re ready to go on the project.
During the project you can choose whether or not to use a commercial credit line for your worker payroll. This works similarly to a credit card, whenever you need to pay your workers, you simply take some money out of the credit line and then at the end of the month you pay it back.
When projects cost more than $100,000 at times and you haven’t gotten paid by your client, credit lines can be life-savers and critical to operating construction companies.
There are 2 types of credit lines, revolving and non-revolving. Revolving lines allow the borrower to withdraw funds as many times as they want as long as it’s within the term of the agreement. Non-revolving lines allow the borrower to withdraw funds up to the limit only once.
How Much Do Construction Loans Cost?
There are a number of fees associated with construction loans, starting with origination fees.
Origination fees are the way lenders get paid for giving out loans, they’re fees you must pay in order to get the loan. The percentage of the loan you’d pay as the origination fee is around 0.5% to 2%. So for a $1,000,000 loan you can expect to pay something around $5,000 to $20,000.
Once you’re approved for the loan, you’re then charged based on the amount of money you withdraw.
So if you get approved for a $100,000 loan and you take out $20,000, you’ll only get interest rates for that $20,000. Interest rates for construction loans can range from 5.50% to 6.50%, with good credit scores (700 and above) helping you secure better interest rates and lower origination fees.
Tips for Financing Your Construction Business
Look into Equipment Financing
This is for people interested in buying or borrowing physical assets for their construction company. You can either get an equipment loan, or a lease.
These are less risky than other types of loans because if you don’t pay the loan back, the lender can simply repossess the equipment.
Look into Bank and SBA Loans
Small business loans are, unsurprisingly, one of the most helpful and useful type of loans to fund a construction business.
They’re loans guaranteed by the SBA (Small Business Administration) and carried out with the banks.
They can guarantee much more than the typical bank loan, the tough part is qualifying for it. Your credit score needs to be higher than usual; you must have at least 2-3 years of being in the specific company. Here are some general guidelines.
Find Cash-Flow Management Opportunities
Improving the cash flow in a construction company is critical to success, and there are many ways to improve this aspect of business.
One of the ways is to really get a handle on the economics of your business. What is the profit you typically see in projects, how long does it normally take to finish projects, these are examples of important questions you need to find out because once you have clear objectives for your company, everything else suddenly becomes a lot smoother.
For example, if a construction company usually gets 1 out of 10 projects they bid, and the CEO hosts a big company meeting and announces he wants to improve it to 3 out of 10, then every task that is being done after that will trigger the question “is this task helping this company get to our goal”.
This is a very simple tactic that can instantly increase some of the cash-flow in your construction business that I don’t see many companies doing.
Revenue-Based Financing
In revenue-based financing, businesses seek to raise capital by inviting investors to invest in them in exchange for cuts in the business’ profits in the future.
Just like the name implies, the amount of money the investor makes in revenue-based financing is entirely dependent on the revenue the business is bringing in, so if an investors cut is 10% and the business makes $10,000,000 in sales, then the investor will make $1,000,000. But if annual revenue plunges to $100,000 the next year, the investor will make $10,000.
There are many revenue-based financing firms out there and getting one to invest in you and your construction business can be a challenge but can give you a potentially huge boost.
Peer-to-Peer Lending
Peer-To-Peer Lending is obtaining loans straight from other people. This cuts out the banks that are traditionally in the middle of the entire process.
There are entire websites dedicated to managing these person-to-person loans, and it can be a much more accessible alternative to getting loans from banks.
Who Is Eligible for Construction Financing?
In order to qualify for a construction loan, you need to fulfill a list of requirements, which includes but is not limited to:
- A qualified construction team
- A Plan for the construction project
- An origination fee to cover part of the project and give the lender some insurance
- The appraisal of the property value
Next Step… Estimating.
Construction financing is the first step to building projects, and estimating is the second.
About the Author
Daniel Quindemil is the founder of I AM Builders. A company that provides estimating services to builders and construction companies all around USA, with databases based on zip codes for laser-focus accuracy. You can call him at 1-866-367-4939 or visit IAMBuilders.com for questions about construction financing or to learn about his business.
