A mortgage agreement will often have lower interest rates but higher monthly payments than a construction loan. This is because the borrower will need to begin paying down the balance of the loan as well as the interest. This turns out to be ideal for the small business owner, as a business can't start bringing in money until its physical location is constructed.
A construction loan is disbursed according to a building schedule, so the builder can pay for each part of the physical construction on time. The lender makes further disbursements when the builder meets certain milestones. For instance, the lender may provide an initial small loan to pay for clearing the site and pouring the foundation. Once the foundation sets, the next phase kicks in, and the lender gives another portion of the loan to the lender to pay for the construction of the frame. This process continues until the building is finished.
Obtaining approval for a construction loan is much like obtaining approval for other major loans like mortgages or car loans. The borrower must provide sufficient proof of assets and income to show the lender that he or she will be able to pay the interest on the loan for the duration of the building process. The borrower's credit rating will likely be assessed, and proof of state residence and U.S. citizenship will need to be confirmed.
Construction loans fall under the category of "story loans." This means that they are awarded on a case by case basis depending on the borrower's plans and needs. The borrower may have to pitch a business plan to prove that he or she will bring in enough money for monthly payments to pay off the balance of the construction loan through a traditional mortgage. Because each construction project is different, the amount of your construction loan will be determined on a case by case basis. The borrower and the lender will work out the disbursement plan together.
The constructed building will most likely serve as collateral if the borrower fails to pay back the construction loan amount in full with cash or through a mortgage. In other words, if the borrower doesn't pay, the bank gets the building.
Many lenders offer a package known as a construction-to-permanent loan. This bundles the construction loan and long-term mortgage into a single financing instrument. The borrower pays interest on the loan while construction is underway and begins paying down the balance when construction is finished. Generally, construction-to-permanent loans are a good idea. They reduce the amount of paperwork the borrower needs to do and keep the borrower with the same lender through the entire process.
The only downside of construction-to-permanent loans is that they may not provide the lowest mortgage interest rates. Potential borrowers and small business owners should shop around for different mortgage plans before finalizing a construction-to-permanent loan with a single lender. Borrowers may be able to find better mortgage rates with a different lender. One lender may offer attractive construction loan options, and another may offer better mortgage options. As with any major loan agreement, borrowers should always do their research before signing anything.