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The Basics of Construction Lending for Business Owners

Here are the key things to know when considering a construction loan for your project:

  1. Banks are competing for your business. In the interest of competing, a bank will issue an appealing approval letter that spells out the basic terms of the loan, such as interest rate, payment period, estimated monthly payment, and high-level loan conditions. The fact is that the loan-closing conditions will be issued separately once an approval letter is signed and a borrower has begun the loan-closing process. It is important that a borrower understands that the approval letter is not the actual loan agreement and does not contractually obligate the bank to move forward if loan conditions are not met. Since the closing conditions are not listed on the approval, at times those closing conditions can become a sore point for the borrower, as they may not align with the initial expectations.

  2. Bank loans are based on proof of existing revenue. For most business loans, and all construction loans, banks do not perform projection-based lending; the loan amount and monthly payment are determined by existing and current revenues over the last three years. The loan does not consider any possible revenues of the prospective new construction once completed.

  3. Construction loans are disbursed over time, not as a lump sum. Lenders can take different approaches to the disbursement of construction funds, but generally for sums over $500k, they will require the funds to be disbursed as work progresses. Bank requirements may include proof of work completed, proof of payments by contractors, and lien waivers from contractors for the payments made. Construction lending is higher-risk lending and as such is more closely monitored.

  4. Construction loans often have a unique loan structure and interest rate for the duration of the project. Often the additional risk of construction also comes at a much higher interest rate. The terms, requirements, and structure of bank loans vary from one institution to the next, but generally a construction loan is structured with a higher interest rate during a set construction duration (say 18 months) with disbursements made as work is invoiced, with only the disbursed funds accruing interest. The borrower will either be required to pay the accrued interest or will be allowed to let the interest accumulate, and then roll that interest amount into the final loan amount. Once the construction period is complete the loan is termed out for the amount disbursed (plus any accrued interest) and rolled into a new loan, with a new (typically lower) interest rate, a set pay-back period, and a different set of loan conditions (such as prepayment penalties).

  5. Construction loans require continuous assessment of your business financials. In the closing conditions requirements, the bank will specify additional financial reporting during the disbursement phase of the construction loan. Generally, the bank will monitor the borrower financials, liquidity, and credit rating throughout the construction period. Should the bank find a deviation from expected trends, such as unforeseen additional debts, declining financials, or unexpected drops in liquidity, they will reserve the right to pull the loan. Typically, the bank will work with a borrower to mitigate this risk, and may require additional loan collateral or guarantors. However, in the worst case they would cease further funding on a partially completed project and require the loan to enter repayment without their support in funding further construction. It is critical that a borrower be transparent with their bank about all financial plans in advance, so that no surprises occur that upset their financial agreement with the bank.


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