From flipping houses to renting out properties, there are countless ways to build your investment empire.
But it all starts with funding.
With solid funding, you can build the real estate business of your dreams. Without it, you’ll be stuck dreaming about a real estate business.
As I’ve learned myself, there’s so many options out there (ever heard of private money lending?), but the one I wanted to talk specifically about in this article is a construction loan.
So, what is a construction loan, and is it right for you?
Sit back, relax, and get ready to learn everything you need to know about it.
What is a Construction Loan, and How Can Real Estate Investors Use One?
Construction loans are money you borrow from a bank on a short term basis, typically for one year.
Individuals and real estate developers are eligible as long as they fulfill the requirements (more on that later).
A construction loan isn’t just any old pile of cash. It’s specifically designed to pay for:
- Building a home from scratch
- Major house renovations
- The nuts, bolts, and even kitchen sinks that will bring your property dreams to life
- A smorgasbord of miscellaneous costs, from the first stroke of your architect’s pen to the last sweat of your construction crew’s brow
Advantages of a Construction Loan
The primary advantage? A construction loan finances your fixer upper with favorable and affordable terms.
This type of loan is also flexible. The terms can be as short as 6 months or as long as a few years, depending on your capability to pay.
Plus, you’re required to pay only the interest while construction is ongoing.
But the most appealing part is that you can convert a short-term construction loan to a long-term mortgage, which has lower interest and monthly payments.
Talk about a win win!
Disadvantages of a Construction Loan
Like all loan options, a construction loan comes with it’s fair share of disadvantages, including:
- It requires higher interest rates
- You need to dance through hoops of approval, multiple inspections, and a pile of paperwork
- The bank releases the loan amount in installments
- If your project goes over budget, you’ll have to shoulder the excess
- Construction delays can incur penalties
Construction Loans Vs. Traditional Mortgages: What’s the Difference?
Step into the financial ring and let’s discuss!
In this corner, we have the mighty construction loan, flexing its muscles with short-term, high-intensity funding for building your dream project.
And in that corner, the stalwart Traditional Mortgage, a tried-and-true long-term, low downpayment financing champ for buying homes that already stand tall.
Construction loans are like your project’s personal trainer, pushing you (and your funds) to the limits with higher interest rates (8.125% average as of July 2024) and making you sprint to the finish line of building or renovating.
On the other hand, traditional mortgages are more like a marathon runner, pacing you through the decades with steadier, often lower interest rates.
The construction loan shouts, “Alrighty, let’s build something great!” while the traditional mortgage asks, “Okie dokie, who’s ready to settle down?”
In this financial face-off, the choice between building anew or buying existing is yours to make.
Choose your fighter wisely!
Types of Construction Loans
That’s right, there’s more than one type of construction loan, each with it’s own intricacies. These include:
Construction-to-Permanent. A shapeshifter that morphs into a traditional mortgage upon completion of your castle.
Stand-Alone Construction. The lone wolf of the pack, which requires you to settle its debt before taking on a separate mortgage for your finished fortress.
Renovation. Perfect for the investor who finds beauty in the bones of a fixer-upper and is ready to breathe new life into old walls.
Owner-Builder. Your good old DIY project that allows you to wear 3 hats — property owner, loan seeker, and building contractor.
Construction Loan Requirements
So, what does it take to receive a construction loan? Here are a few of the current requirements.
1. Credit Score
Lenders want to see numbers that sparkle and shine brighter than a newly polished crown. A minimum of 620 ensures you’re as reliable as a knight in shining armor.
2. Debt-to-Income Ratio
45% or lower proves your wallet is sturdy enough to handle the construction loan repayment and any unforeseen construction costs.
3. Builder/Contractor
Most lenders will vet and approve your builder’s license and insurance against theft, vandalism, and inclement weather conditions.
To save time and increase the odds of approval, I recommend you pick one from the National Association of Home Builders directory.
4. Detailed Construction Plan
Convince lenders your castle won’t crumble with these docs:
- Builder’s contract
- Blueprints
- Design
- Line-item budget
- Construction timeline
- Payment schedule
Make sure they’re as detailed as a wizard’s potion recipe.
5. Down Payment
Prepare 10% to 20% of the project cost.
How to Get a Construction Loan in 2025
Sound like a construction loan is right for you? If so, you’re probably wondering what the first steps are. These include:
Step 1: Gather your financial artifacts.
- Gleaming credit score and debt-to-income ratio
- A treasure trove of savings for the down payment
- Project plan so compelling it could charm the scales off a dragon
- Reputable builder
Step 2: Consult with a sage (a.k.a. loan advisor).
This expert will not only guide you through the process but also scrutinize each piece in the above list like a specimen on a petri dish to ensure they’ll pass the lender’s test with flying colors.
Step 3: Purchase construction project insurance.
Yep, that’s a thing, and it’s best to get one with comprehensive coverage. Before paying your premiums, check with your lender to make sure the plan meets their requirements.
Step 4: Submit your application.
And wait for the approval!
With determination, you’ll secure the construction loan of your dreams. Forge ahead, intrepid investor, for fortune favors the bold in 2025!
The Bottom Line: Construction Loans for Real Estate Investors
A construction loan can be the exact type of funding for your first or next real estate investment. Keep in mind that like a delicious buffet, it’s just one of several funding options in the real estate game — and it’s up to you to choose what’s right (and tasty) for you!
