Lenders issue construction loans for the creation of new buildiings. These may be residential properties, such as single-family homes, or commercial properties, such as shopping centers, office buildings, warehouses, hotels, and industrial facilities. The funds cover building costs, including raw materials, labor, and equipment leasing or purchasing.
Private lenders usually offer construction loans on a unique schedule. Instead of disbursing loans as lump sums to borrowers, lenders disburse them in tranches as the building project goes through various stages.
A typical building project has five core stages: base-down, frame-up, lock-up, fixing, and completion. At each of these stages, private lenders release a portion of the loan to cover related expenses.
At the base-down stage, lenders release financing to cover the building of the foundation. At the frame-up stage, funds cover raising the structure and exterior framing. At the lock-up stage, money covers the brickwork. At the fixing stage, financing covers the internal work, such as building internal walls and installing kitchen and bathroom fixtures. Finally, at the completion stage, funding covers wall and ceiling finishes and electrical appliances. This layered model ensures that builders have enough money for every stage of construction, minimizing the risk of funds running out before completion.
Building on their one-of-a-kind loan issuance model, construction loan lenders schedule unique repayment terms for borrowers. During the building process, borrowers pay interest-only payments on the amounts they withdraw. When the building is complete, borrowers pay a lump sum for the entire amount they received plus interest.
In some cases, private lenders waive interest payment during the building process, but this does not mean that the interest is forgiven - it accrues and is added onto the principal. In the end, when the building is complete, the borrower must pay a higher lump sum.
In practice, however, property developers do not pay these lump sums after completion. Instead, they refinance the loans into permanent mortgage-type loans and pay the principal plus interest payments monthly for 15 to 30 years. Therefore, borrowers must apply again for a traditional loan when their property is finished. This is called multiple close financing.
Reacting to the needs of their borrowers, many private construction lenders offer the option of borrowing two loans as a single package - a construction loan and a permanent loan. The construction loan covers development, while the permanent loan converts or modifies the first loan into a traditional mortgage. This all-in-one loan is known as single-close financing.
Single-close financing has many benefits. The first is convenience. Borrowers apply once for a construction loan and receive two loans in one package. The package also offers more security for construction projects. Since the rates are locked early in the project, a borrower can budget easily for the future.
Multiple-close financing, on the other hand, is preferred by borrowers who want flexibility. While this method requires them to apply for two different loans, they can shop around for loans with lower interest rates. They do not have to settle for the limited offerings of one lender.
This flexibility, however, comes at the expense of security. Should the borrower’s financial capabilities or the economic environment change during construction, the borrower may find difficulty in securing a second loan or getting it at a low rate.
