What are construction loans, building loans and construction finance?

Whether you’re working on a commercial construction project, a self-build or home extension, securing funds can be a challenging task. Construction projects are complex and unpredictable, so access to construction finance and building loans can make all the difference. However, the range of options isn’t always easy to navigate but it’s important to understand what is available and how much it costs before making any big decisions.

The options for construction finance include secured loans and unsecured business loans to equipment finance. You may find yourself using different financing options at different stages of your business, so it pays to understand them all.

In this article we will explain how building loans and construction finance work, provide you with the information you need, and address key concerns and frequently asked questions about the sector.

What is construction finance?

While building loans come under the general umbrella of construction finance, the term ‘construction finance’ is more frequently used to refer to funds used to plug the gap between work completed and payment for that work.

Construction finance covers the range of finance tools used to fund and sustain new projects in the construction sector. The capital from construction finance can be used for a range of purposes, including paying subcontractors, buying raw materials, and managing costs on the go when cash flow is uncertain.

This is especially important where issues like late payments and extended payment contracts can hold up housebuilding, as well as other infrastructure projects, and cause difficulties for companies with goals to meet and wages to pay. This is where construction finance can come in.

How does construction finance work?

Put simply, construction finance helps to avoid cash flow problems and allows firms to purchase much-needed materials, hire equipment and pay contractors. It is particularly important for small construction companies.

Among other things, construction loans allow businesses to access significant proportions of the value of outstanding invoices, sometimes as soon as they have been sent out. Known as construction factoring, it means that cash is available quickly without having to wait months for payment. In some instances, it can also be used for payment applications and partially completed work.

In essence, the lender is providing a prepayment – a construction loan. Of course, as with other loans, a number of factors are taken into account, including credit score and credit history as well as other debts.

Quick-fire facts about construction finance

• In general, construction finance is used to bridge the gap between ongoing work and the payment for that work.
• This kind of finance tends to be short-term.
• Construction finance is a crucial element of flexible funding for construction firms under pressure to meet building targets.
• It allows firms to raise funds against new applications for payment and outstanding invoices.
• Construction finance helps companies to keep building, hire equipment, pay for materials and settle wage bills.‍

What is a building loan?

Typically a building loan is a short-term loan used to pay for the cost of constructing a building project. Building loans cover a number of different types of builds, and definitions vary to such terms as construction loans, self-build loans, home-building loans, homeowner loans, house-building loans, home improvement loans.

Building loans are different from traditional mortgages, which are based on a property’s value and its price in relationship to similar sales. In the case of a building loan, the total sum is dependent on the cost of the build. Unlike mortgages which are given in the form of a one-off lump sum, a building loan is typically paid out in instalments on a pre-agreed schedule. This is known as ‘draws’.

As previously mentioned, building loans are shorter in duration than ordinary home loans and they can incur higher interest rates. A year-long contract is not uncommon as the term must allow for adequate building time.

Quick-fire facts about building loans

• Building loans cover the cost of a building project.
• The amount loaned is not based on the value of the finished property.
• Auction finance is another short term funding option to secure property. So is a commercial mortgage but this is a long term funding option.
• Rather than providing all the money up front, the lender pays out in instalments.
• The payment schedule – draws – is determined by the different stages of the building process.

What is the difference between a building loan and a construction loan?

The difference between a building loan and a construction loan is largely related to the size and scope of the project. A construction loan is generally intended for larger, new-build projects, such as the construction of a new home or commercial property. They are released in stages, corresponding with different phases of the construction process. 

On the other hand, a building loan is typically associated with smaller projects like home improvements, renovations, or extensions. These loans might cover the cost of converting a loft, extending a kitchen, or adding a conservatory, for instance. While some lenders may release funds in stages similar to a construction loan, others might disburse the entire amount upfront, given the smaller scale of these projects.

How to Fund a First-Time Construction Project

Funding your first construction project is a riskier proposition for lenders, but if you have a solid business foundation you may still be able to secure finance.

1. Evaluate Your Project’s Needs

Before seeking financing, thoroughly assess your project’s requirements. Consider the scope, timeline, and budget. Detail all expected costs, including materials, labour, permits, and contingency funds for unexpected expenses. This clear understanding will help you determine the amount of funding you need.

2. Explore Financing Options

There are several financing options available for first-time construction projects. Construction loans are designed specifically for construction projects, so their staggered payments may suit your plan better. Otherwise, a building loan suits smaller projects or home improvements and can be disbursed in stages or as a lump sum.

If you’re a construction company, a small business loan might be suitable as it provides flexibility and can cover a variety of expenses.

3. Prepare a Solid Business Plan

Lenders will want to see a comprehensive business plan. This should include:

• Project Overview: A detailed description of the project.
• Budget and Cost Estimates: An itemised list of projected expenses.
• Timeline: A realistic schedule from start to finish.
• Team Details: Information about the builders, contractors, and architects involved.
• Market Analysis: Demonstrate the demand for your project.

A well-prepared business plan shows lenders that you’re organised and serious about your project.

4. Check Your Credit Score

Your credit score plays a crucial role in securing financing. A higher credit score can lead to better loan terms and lower interest rates. Obtain a copy of your credit report and check for any errors. If your score needs improvement, take steps to boost it before applying for a loan.

5. Gather Required Documentation

Lenders will require various documents to assess your loan application. Commonly requested documents include:

• Proof of identity
• Financial statements
• Detailed project plans
• Planning permissions
• Builder insurance
• Contracts with architects or contractors

Having these documents ready can expedite the application process.

6. Apply for Financing

Once you have your business plan, credit score, and documents in order, it’s time to apply for financing. Alternative lenders like iwoca can provide fast decisions based on your application within 24 hours. Find out how much you could borrow here.

How much do building loans cost?

The cost of building loans varies – much depends on the finances of the individual or company, including their existing debt and recorded credit history. The requested loan amount will also have a bearing on the interest rate as will the agreed repayment schedule.

Construction loans make it possible to build when circumstances might otherwise prevent it. But it’s important to consider construction loan interest rates. If you want to draw on your construction loan, you will probably be paying a variable rate – so that rate can go up or down. In lots of cases, construction loans are interest-only loans, meaning interest is paid on the borrowed amount and not on the loan balance.

When financing new construction, a large down payment is also a typical requirement. As there is more risk with a construction loan than a standard home loan, interest rates are likely to be higher. Within the construction finance sector, the type of loan will determine cost. A small business loan works differently to a building loan even if they can serve the same purpose: construction.

What are the requirements for a construction loan?

There are often stringent requirements for a construction loan approval. Before approaching a lender, you’ll probably want to ensure that you’ve hired a qualified builder, put together a detailed plan for the build, and have good credit. Lenders may also require you to provide supporting documentation, such as proof of identity, planning permissions, builder insurance, and contracts with architects or contractors. These documents help demonstrate the viability of your project and provide lenders with assurance of its success.

Construction Finance FAQs

Do I need a deposit for a house-building loan?

Almost certainly. Lenders usually ask for between 20% and 25% of the loan as a deposit.‍

How much can I borrow on a construction loan?

This depends. Construction and building loans are supposed to cover the cost of the build so amounts borrowed vary dramatically depending on the project.

The lender will want all kinds of information from you before deciding how much to pay out so it’s important to be realistic – and honest.

How long will it take me to get a construction loan?

Again, this varies. But if you have all your ducks in a row, the process can be very quick and, in some instances, completed online. Applying for an iwoca’s Flexi-loan takes minutes, for example, with the ability to get the funds in 24 hours. 

What is the typical length of the contract?

On average, building loans are short-term, usually around a year. Some options can include a line of credit where you can draw down additional funding up to an agreed limit.

What are ‘draws’?

Construction finance (as opposed to straightforward business loans) includes a schedule of draws. These are payment dates spread out across the build which coincide with important events in the process such as foundations being laid and waterproofing the property.

Can I take out a building loan for home renovations?

Yes. Although there are lots of loan options for something of this nature so it pays to shop around. Do your homework in order to ensure that you get the best deal.

Is it better to get a construction loan over other types of loans in the UK?

Deciding whether a construction loan is better for your project compared to other types of loans depends on your specific circumstances and needs. Construction loans offer unique benefits, such as the ability to draw down funds as needed and interest-only payments during the construction phase. This can provide flexibility and help manage cash flow during the project.

However, construction loans also come with certain risks and considerations. They typically have higher interest rates and can be more complex to secure compared to traditional mortgages. Additionally, the drawdown process requires careful budgeting and monitoring to ensure funds are used appropriately.

It's important to carefully evaluate your project, financial situation, and long-term goals before deciding on the best loan option for you. Consulting with a financial advisor or mortgage broker can provide valuable insights and guidance to help you make an informed decision.

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