While the housing market often has something that meets the requirements of a prospective homeowner, it can’t always supply our perfect home. In such instances, it might be best to build our own home, or renovate an existing one to better meet our ideal.

If this is your chosen route to procuring your perfect home, you will find that sourcing finance is a bit different from the standard mortgage. Rather than the usual trip to a bank to source the funds required, you’ll need to obtain construction finance instead.

In this article, we will discuss everything you need to know about construction finance, including what it is, how it works, and how you can use it. Let’s get started.

What is construction finance?

Construction finance is a method of raising capital with a view to constructing a new building or renovating an existing one. Construction finance is a short-term option, usually lasting only one year or less. At the end of this period, it is expected that the new property will be built and certified, or the existing one will be renovated. Construction finance also carries a comparatively high rate of interest.

How does construction finance work?

As we mentioned, construction finance comes with comparatively high interest rates. The reason for this is simple – risk. When you obtain a mortgage, the house you buy acts as collateral for the loan. This mitigates risk significantly; if you default on your loan, the bank can repossess the house in order to cover the debt. However, your lender has little use for an unfinished house, so the same risk mitigation factor is missing. The higher interest rates earn the construction finance lender more money, thereby reducing the project’s overall risk.

As construction finance is a short-term finance option, and one intended to fund a project, you need to supply your lender with a concrete plan. Lenders aren’t going to approve an application without a detailed plan, project timeline, and budget. Once you supply these vital documents, your lender will consider the proposal. Assuming they accept, they will begin funding your construction project in line with your budget and construction plan.

During the construction of your new home, you will likely only pay interest on the amount of money you have taken out. Construction finance is a drip-feed, with the final installments coinciding with the final stages of the project. As such, you will only be paying back the loan once the project is finished.

Payment terms

Though construction finance loans are paid in installments, they are not on a timer. Instead, you can expect to receive your funds as each milestone in your build is completed. For example, your lender might provide the initial installment to lay the foundation of the home, and the next to build the frame. The construction progress is assessed by an inspector, which your lender will appoint. They will check the progress of your project and report back to your construction finance lender. If you are hitting your targets, then you can expect to receive your installments without delay. However, if your project is stalling or running into obstacles, then you’ll need to overcome these delays in order to receive the next installment.

At the end of the project, you may be able to transition your construction finance into a standard mortgage. This is called a construction-to-permanent loan, though it is highly dependent on both your particular lender and the initial purpose of your construction loan. If you opted for a construction-only loan, you would have to take out a mortgage specially created to pay off and replace that loan.

What can construction finance be used for?

Construction finance can be used to fund many factors of a construction project. It can be used to pay the costs of contractor labour, building materials, and transport costs, but also the cost of the land on which the new house will be built.

However, construction finance is not appropriate for every part of a project. For example, construction finance is not usually used to fund the purchase of furnishings, such as tables and chairs. You will need to use another form of finance for such purchases, like a personal loan or development finance. While this is somewhat limiting, construction finance can be used to fund the installation of permanent fixtures. Such as fixed lighting or other appliances.

How to obtain construction finance

Broadly speaking, obtaining construction finance is largely similar to obtaining a mortgage. There’s a lot of overlap regarding the factors you should consider, but there are also a few unique aspects to it. Here’s how you can get your first construction loan.

First, you’ll need to meet a few prerequisites in order to have your application considered. You’ll need the usual factors. Such as a strong credit rating, proof you can repay the loan. If you have any debt, it must be offset by a comparatively high income. Next, you’ll need to be able to make a deposit. The exact amount will depend on your loan and level of risk. Lastly, you’ll need to provide a detailed plan, timeline, and budget, as we mentioned previously. Anything else you can provide to demonstrate low risk will help you too.

If you can provide your lender with an estimate of the finished home’s value, this will likely be to your benefit. If you plan on changing the construction loan into a standard mortgage, being able to demonstrate the value beforehand will add more detail and likely result in your lender viewing your project as lower risk.

Conclusion

Construction finance can be a useful, if expensive, method of funding your next property development project. If you intend on using this option, consider securing homeowner’s insurance if you haven’t already. Despite not living in the new build, it will be insured in case something disastrous happens during the construction. For example, it will protect you if an electrical fault causes a fire. This will protect you and your project, giving it a greater chance of success.