Construction Financing: What to Know

At Texas Mortgage Capital Corporation, we understand how challenging it can be to navigate the complexities of obtaining a construction financing loan. With the construction industry booming, the need for financing and loans has never been more necessary. We have taken the time to create this comprehensive guide to help our clients better understand what construction financing is, how construction financing loans work, as well as the eligibility criteria for such loans.

Construction building

What is Construction Financing?

Construction financing is a loan that finances the construction of a new building, a home, or a renovation of an existing property. Typically, the loan covers the cost of construction projects from start to completion. Construction financing loans can be daunting because the loan amount is significantly larger than the amount of the standard mortgage loan. Therefore, construction loans are usually temporary loans that are used to fund the project's overall costs with interest paid monthly until the completion of the home or building.

How Does a Construction Financing Loan Work?

Construction financing loans are generally short-term loans that may require monthly interest payments. These loans have a rather complex, multi-step process that evaluates the borrower's level of risk, the project's estimated costs, and the market analysis of the property. The breakdown of the building process is carefully evaluated, including the estimated costs and timeline. The construction period is divided into different disbursements called "draws."

On each release of funds, an inspector scores the work done. If the inspector approves the work, they will inform the lender and the funds for the next draw will be released. Two types of loan structures exist: a construction-only loan and a construction-to-permanent loan. The primary difference is that a construction-to-permanent (also known as "single-close" loans) loan rolls over the construction loan into a traditional mortgage when the construction is completed. Additionally, permanent financing is added to the loan which ensures long-term coverage.

What are the Eligibility Criteria for Construction Financing?

To be eligible for a construction financing loan, there are certain requirements that need to be met. First, the borrower's credit score is an essential factor when obtaining a loan. Essentially, your credit score determines how much and what type of loan you can obtain. A credit score of 700 is typically required for a construction-to-permanent loan and under 650 for a construction-only loan. Second, you will need to provide detailed plans for the construction project, including blueprints, schematics, and permits. Third, a schedule of expected costs and a timeline to completion must be included. Lastly, borrowers must be able to make monthly payments on the loan which can include interest.

What Happens if the Construction Project Goes Over Budget?

In some cases, a construction project can go over budget, which can cause some complications. The lender inspects the work done, which mitigates the risk of overspending. However, if the project goes beyond the estimated timeline or beyond budget, the borrower may be required to personally finance the additional expenses. Nevertheless, it is best to discuss such risks beforehand with your contractor to ensure there are no possibilities of encountering these situations.