What is a New Construction Loan?

A new construction loan is a financing option that applies specifically to the costs associated with a new building project. Construction loans are issued both for commercial and private projects, though some lenders may deal exclusively with one type. The terms of a construction loan, and the process for repayment, may be slightly different from traditional loans, and can be especially attractive to those who are planning on building.

For a private new construction loan, such as that used for new home construction, there may be an agreement that only the interest will be paid on the loan during the actual construction phase. This will help those who are still paying living expenses at a different location, thus making it slightly easier for them to get the project done. Once the construction is completed, the balance will then likely be transferred into a more traditional home loan, such as a standard mortgage. The new construction loan can be structured in such as way that the transition happens seamlessly, with only one set of closing costs.

Like any type of secured loan, the lender will want some guarantee of the value of the new construction. For a private loan, this means the lender will likely expect the builder to self-finance a portion of the costs, serving the same function that a down payment would serve in a traditional home purchase. The lender may offer better interest rates, depending on how much money the builder can put down on the project.

A commercial new construction loan will often involve a couple of different tests to determine how safe of an investment the project is for the lender. These tests relate to profitability. There are formulas a lender uses to determine the best investments. Most of these involve a certain projected profit margin. While the formulas can be helpful, there are no guarantees that profit will be realized. That is the reason why most lenders will only agree to fund 80 percent to 90 percent of the project. The equity is used as collateral. If the project fails to reach its full money-making potential, the lender is the first to get repaid.

In addition to monetary terms of a new construction loan, lenders may impose other requirements as well. These include working through a general contractor that is bonded and licensed. This protects the lender and owner in the event the workmanship is not up to quality standards. Without this guarantee, the lender could open itself up to more risk than it could likely afford.