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How Do Construction Loans Work?

How Do Construction Loans Work?

When most borrowers think of a real estate investment, the first thought that likely pops into their mind is one of acquiring an existing property.  In many cases, this is indeed true, but not always.  In some situations, an individual or company may acquire a vacant piece of land or lots and construct something on it.  When this is the case, they will require a special type of financing known as a construction loan. In this article, we will describe what a construction loan is and how they are unique, particularly with regard to their monthly interest payments.  Let’s start with a simple description of a construction loan.

What is a Construction Loan?

A construction loan is exactly what it sounds like, it is a lending facility used to finance the construction of something.  It could be a new home, residential community, apartment building, or any other commercial real estate that a lender is willing to finance.  When compared to a traditional loan – like a permanent mortgage – construction loans have several unique features:

  • Loan Amount:  Construction loans can be obtained for almost any amount of money, but a lender will typically cap the loan amount based on a percentage of the construction costs or a percentage of the “as complete” value.  For example, a lender may advance up to 85% of the estimated construction cost, which means that the borrower would have to make a down payment of 15% to qualify for loan approval.
  • Interest Rates:  Unlike a traditional mortgage or permanent loan – which usually has a fixed rate – the interest rate on a construction loan is more likely to be variable rate.  If it does have an adjustable rate, it will typically include a rate index and a margin.  For example, the mortgage rate could be quoted as LIBOR (the index) plus 2% (the margin).  As the rate changes over the term of the construction loan, so will the required interest payments.
  • Loan Term:  Whereas a traditional mortgage loan may have a term of 15 or 30 years, a construction facility has a relatively short term, usually in the 12-24 month range.  
  • Advances:  In a traditional mortgage, the entire loan balance is advanced at closing and repaid slowly over time.  In a construction loan, the opposite is true.  There is a relatively small advance at closing and the remaining funds are disbursed in “draws,” according to a “draw schedule.”  For example, construction for a new house may be financed using a standard 5-draw schedule where approximately 20% of the loan commitment is advanced with each draw.
  • Repayment:  While the property is under construction, the interest-only monthly payments are usually made from an interest reserve account.  Once the term is up, the principal balance must be repaid in a lump sum, which usually comes from a permanent refinance or sale of the property. 

This interest reserve feature is particularly important with regard to how construction loans work.  It is meant to minimize cash outlay during the construction process, which allows borrowers to focus on getting the project completed.  But estimating the interest reserve amount can be tricky because it depends on a number of variables. 

How Is An Interest Reserve Calculated?

Remember, a construction loan balance starts at zero and increases over time.  Ideally, the loan becomes fully funded around the same time construction is completed.  With this in mind, there are a number of ways that construction loan interest can be estimated.  

The most common way for the total interest expense to be estimated is based on the loan’s average outstanding balance over the construction period, the length of the period, and the interest rate.  For example, assume that a borrower obtained a construction loan for the completion of several single- family homes. The loan has a commitment of $1,000,000, an interest rate of 6% and an estimated construction period of 24 months.  Also assume that the loan will have an average outstanding balance of 50% of the total loan commitment.  If this is the case, the required interest reserve can be estimated as $60,000 (($500,000 * 6%/12)*24 Months).  

In more complicated deals, the lender may take a more detailed approach to calculating the required interest reserve.  With this approach, the lender makes a projection of the amount and timing of each draw for the duration of the construction project.  Then, these estimates are used in conjunction with the interest rate to estimate the total amount of the required interest reserve.  This approach is more time consuming and requires advanced knowledge of the draw schedule, which may or may not turn out to be correct.  

Finally, lenders could use a “Dutch Interest” approach where the interest reserve amount is calculated based on the assumption that the loan balance is fully funded from day one.  For borrowers, this is not ideal since it will result in a higher total interest expense.  But it may be a requirement for high-cost private lenders, lenders that need a minimum yield on funds committed, or just because the borrower is unknown to the lender and must prove their ability to execute.  Because this approach is particularly punitive to borrowers, it is used less frequently, but potential borrowers should be aware of it.

How Is Construction Interest Advanced/Paid?

There are also a number of ways that construction loan interest can be advanced from the loan commitment and/or paid to the lender.

One way is for the borrower to fund the estimated interest expense in full at loan closing and set it aside in a separate checking account that is controlled by the lender.  Each month, the lender will debit the account and use the funds to make interest payments on the loan.  Instead of pre-funding the interest expense amount in full, it could also be funded in increments monthly or quarterly based on the experience and net worth of the borrower/sponsor. It should be noted that lenders that are banks commonly require interest reserve accounts (as well as the project’s operating accounts) to be held at their financial institution as a condition of loan approval.  These funds are not counted as additional loan collateral but the lender may be able to maintain full control of them in a default scenario.  Details are described in the loan agreement.  Because these are lengthy, complicated documents, it often makes sense to work with a mortgage advisor like DLS to ensure all terms and conditions of the construction facility are understood completely.

Instead of a borrower funded interest reserve, the interest expense could also “accrue” over the construction term and be tacked onto the outstanding loan balance and paid in a lump sum at maturity.  Alternatively, in a “net funding” scenario, the lender could deduct the interest expense from the cash it advances to the borrower to pay itself. In this case, the cash the borrower receives would be less than the outstanding loan balance to be repaid at maturity.

Because there are several ways that the interest can be advanced/paid, it is critically important that borrowers understand the structure they agree to.  In particular, there are two reasons why this is the case.  First, depending on how the interest is treated by the lender, there could be a significant impact on how much equity a borrower must inject into the deal. For example, if a lender states their loan program provides 80% loan to cost but they exclude interest expenses from their cost calculation, the borrower will actually have to contribute more than 20% of total costs to fund their deal. Second, it could influence the cost of financing. If a lender charges a 6% interest rate but interest accrues onto the loan balance, the borrower will be paying interest on interest, so the effective interest rate they pay over the life of the loan will be higher than 6%.  Both points highlight the importance of working with an experienced advisor to understand the implications of a proposed deal structure.    

Risks and Benefits of Different Structures

For the borrower, the major benefit of various interest reserve structures is minimizing their total cost of construction and addressing cash management needs.  By pre-funding an interest reserve account based on an anticipated draw schedule or in periodic increments over the life of the loan, the borrower only has to pay interest on the total amount advanced, which rises slowly over time.  Pre-funded reserves and “net fundings” also shift the administrative burden of making monthly loan payments to the lender, who will debit the interest reserve account and credit the loan every month or add interest to the outstanding balance.

For the lender, the benefit of a reserve account is to ensure that they get paid interest in ways that address their internal risk management and accounting protocols, while maintaining sufficient control over the funding process.  Often, they will require the borrower to open a joint or lender-controlled account in which interest reserve funds are deposited.  As described above, they will access the account to make the monthly loan payments.  They will also monitor the balance regularly to ensure there are enough funds to make the interest payments through the completion of construction.

For both the lender and the borrower, the major risk of a pre-funded interest reserve account is that it will run out of money.  Whether it is a home construction loan or commercial construction loan, things rarely go according to plan.  There could be issues with the general contractor, the weather, availability of materials, permitting, or labor and they could all result in construction delays.  

No matter the cause, any sort of delay that extends the construction period will increase the risk that the interest reserve account runs out of money.  When/if it does, there are two options.  First, funds could be reallocated from another line item in the construction budget (if available).  Alternatively, the borrower may be required to replenish the account balance from their own funds.  This is not the preferred route, but it happens even to highly experienced operators.

Summary & Conclusion

A construction loan is a type of financing where funds are used to build a ground up real estate development.  Among the many unique features of a construction loan is their short-term nature, their funding over a series of draws, and varied structures, particularly as it pertains to how construction loan payments are made, either from an interest reserve account or otherwise. 

Calculating the amount of the interest reserve is a function of the construction loan amount, the interest rate, and the length of the construction period.  This amount can be estimated at a high level, or it can be calculated using a detailed schedule of loan draws over the construction period.

The benefit of using an interest reserve is that it minimizes interest expense and administrative hassle for the borrower while providing adequate control for the lender.  But if the interest reserve is insufficiently funded, it must be replenished by reallocating funds from another line item in the construction budget or by depositing additional funds.

Interested In Learning More?

Diversified Lending Solutions arranges financing on construction loans.  To learn more about our construction loan types, interest rates, or down payment requirements, visit our website by clicking here.