Construction projects require significant capital, and because contractors do not get full payment until the project is completed, they have to source funds elsewhere. A typical financing option contractors use is a construction loan.
Contrary to what most people think, loans are not only needed during a financial crisis. Instead, they can propel your construction business to its maximum level if appropriately handled.
Different types of construction loans and financing options depend on the type and scale of a construction project.
This article will highlight the uses of construction loans and the best loans and alternative financing options for your construction business.
What is a Construction Loan?
A construction loan is a short-term loan issued by banks to finance the building of homes, commercial structures, and other real estate projects.
A construction loan is also used to pay for renovations of buildings or structures and the installation of electrical or solar power systems.
The terms of a construction loan last between 6 to 24 months. Unlike other types of loans, construction loans are not paid out at once. Instead, they are paid out in installments. Most times, the installments arrive at the beginning of certain construction stages, such as laying the foundation, flooring, or roofing.
Construction loans are often confused with traditional mortgages, also known as permanent loans. However, they differ in some ways.
To start with, construction loans carry higher interest rates than a traditional mortgage. In addition, construction loans have shorter repayment periods than mortgages which can be between 15 to 30 years.
Also, a mortgage is used to buy an already finished house, while construction loans help you purchase land and build a structure. Moreover, only land serves as collateral for construction loans. Mortgages, however, require both the land and the property.
What Can Contractors Use Construction Loans for?
Construction loans cover several building activities, including plumbing, painting, and roofing, as well as the services of electricians, carpenters, renovators, and general contractors.
Nevertheless, the uses of construction loans go further than these. Its other uses include:
- Opening a new construction company: starting any business requires capital. So except you have enough funds in your savings, you'll need a loan to set up your construction business.
- Bidding for new projects: with the high competition in the construction industry, having enough capital can help you land clients.
- Land acquisition: the land is what the foundation and the building stand on. Construction loans can be used to purchase land, thereby ensuring the start of projects.
- Purchasing building materials: the prices of building materials are on a constant rise, and the initial payments made by clients cannot cover them all while handling other parts of the construction project.
- Closing costs: construction loans also help to handle all expenses incurred at the end of a construction project.
- Expanding the production team: frequently, the services of subcontractors are needed on site. Construction loans cover their payment and even that of other construction workers.
7 Best Loans and Financing Options for Construction Companies
Every construction company and project has specific needs. Therefore, contractors should consider these needs before applying for a loan. Thankfully there are various loans and financing options to choose from. Here are some of them.
1. Business Lines of Credit
Business lines of credit cards work just like credit cards. A limited amount of money is provided and is gradually withdrawn for business purposes.
The card lets you access this money at any time. And just like credit cards, only the amount withdrawn accrues interest.
However, it has longer terms, and the rates are lower. The interest and principal are simultaneously paid back with monthly payments. Also, once the borrowed amount is paid back, you automatically get access to the credit again. You won't even have to reapply.
It is a flexible financing option that covers many construction business activities, including payment of invoices, equipment purchases, wages/salaries, and office needs. Its flexibility makes it easy to respond to unexpected expenses and opportunities.
Certain criteria are needed to apply for business lines of credit. The lender (the bank) determines these requirements.
Firstly, your business must have run for a minimum of six months. Your yearly revenue must be at least $50,000, and you should have a credit score of 560. Note that these eligibility criteria range from bank to bank.
Benefits
- It helps improves your credit score
- It is very flexible
- Only money spent accrues interest
Disadvantages
- They have adjustable interest rates, allowing lenders to charge rates even when it is unfavorable for the borrower.
- A required minimum is often required
- It has a very high credit score requirement
2. SBA Loans
The SBA (Small Business Administration) finances commercial projects by partnering with banks or credit unions that give contractors and construction companies.
The SBA secures 85% of the loans if the borrower can't repay them. It provides the lender security and encourages them to give more construction loans at favorable terms.
Compared to other financing options, SBA loans have the lowest rates and longer terms, up to 25 years. They are also known for large loan amounts (up to $5 million) and low down payments.
SBA loans have rigorous requirements, including a minimum personal credit score of 650, minimum annual revenue of $100,000, and about two years of business operations. It is why many applications are rejected.
Regardless, some borrowers secure these loans without meeting the above requirements. They do this through the SBA Loan Guarantee Program.
The application process is intensive and requires highly detailed personal and business financial records. Processing applications can take months, and there's no assurance they'll be approved.
Benefits
- More considerable loan amount up to $5 million
- Partially secured by the small business association
- Longer loan terms
Disadvantages
- Rigorous application process
- High qualification requirements
- Long processing and approval
- Loan use restrictions
3. Bank Loans
Banks offer construction loans with good terms and favorable rates based on the loan size and your business's credit history. Bank loans also have strict qualification criteria, although not as rigid as the SBA.
Similarly, banks take weeks and even months to process applications without guaranteeing approval. In addition, some loans come with certain spending restrictions.
Most times, banks would instead give loans to well-established businesses. However, this and the unstable cash flow, seasonal volatility, and high construction industry risks make it difficult for contractors to secure loans from banks. As a result, it is notably harder for small and new businesses.
Therefore, it is ideal for construction businesses with a relationship with banks. In addition, construction companies with long-term funding needs and those looking for large loans can also benefit from bank loans.
Benefits
- Lower rates
- Longer and more favorable terms
Disadvantages
- Strict qualification criteria
- Long application processing
4. Invoice Factoring
Another popular financing option for construction companies is income or invoice factoring. It is a non-loan type of financing known as accounts receivable financing.
It is common for contractors to have multiple invoices unpaid or still in the payment process. By selling their unpaid invoices to factoring companies, construction businesses can free cash flow tied down by outstanding invoices.
Invoice factoring provides instant access to working capital without waiting for customers to pay. Although with high costs, contractors can obtain 70% to 90% of the value of unpaid invoices from lenders.
In other words, your unpaid invoices are sold at a discounted price to receive the net amount in cash. Then, the lender collects the payment from your customer and sends you any remainder after deducting the advance and fees.
Since the funds are guaranteed and secured by your outstanding invoices, the application qualifications are easier to meet. Still, your customer's credit score is considered before your unpaid invoices are approved.
Your business revenue, cash flow, years in business, and public records are other factors factoring companies look into.
Also, application processing and approval can take as little as one business day. Invoice factoring is ideal for construction businesses with lower credit scores who need quick access to capital and are looking for smaller loans. It is especially suitable for construction companies with long billing cycles.
Benefits
- It is guaranteed by invoices that serve as collateral.
- Provides quick access to capital without waiting for customers to pay
- No interest payment
- No restrictions on how you spend the funds
Disadvantages
- High fees
- Shorter terms
- Factoring contractors are sometimes very confusing
- The intrusion of relationships with clients
5. Equipment Financing
Equipment financing spreads the payment for equipment and machines over many years. This financing option helps you acquire expensive construction equipment such as forklifts, bulldozers, excavators, lifters, and loaders, without running out of funds.
It is not restricted to heavy machines; contractors can also use it to purchase office equipment like computers, furniture, company vehicles, and refrigerators. In addition, equipment financing allows you to own all this equipment rather than lease them.
Lenders provide about 80% to 100% of the cost of the equipment. The lender determines the length of payment based on the loan amount, terms, and interest rate. Payments are made in installments, usually every month.
In equipment financing, the equipment serves as the collateral, removing the need for down payments. For this reason, the requirements are very flexible, and good credit scores are not necessarily considered.
However, some lenders will need you to be in business for a minimum of one year, have at least $50,000 annual revenue, and have a credit score of 650.
Benefits
- Easy to secure
- Lower rates
- Lets you own the equipment
Disadvantages
- Funds can only be used to acquire specific equipment
6. Merchant Cash Advances
Businesses that do not qualify for other construction loans can get funds from MCA (Merchant Cash Advances). It is a non-loan financing choice known as an asset purchase.
Rather than provide you with a huge sum of money to be paid back, lenders would purchase a fraction of your future sales by offering capital in advance. MCAs can provide capital up to $500,000. Nonetheless, they come at high costs due to their high factor rates.
As opposed to installment payments of loans, merchant cash advances are paid through automatic credit and debit card sales deductions. These deductions are made till both the advance and additional fees are paid.
Credit requirements in acquiring merchant cash advances are moderate. As a result, less focus is placed on credit score and financial history and more on factors such as your business revenue and the potential or health of your construction company.
Application processing and approval can be made within one business day. This makes it a good financing alternative for construction businesses needing fast access to working capital. It is also ideal for companies that accept and process many credit card transactions.
Benefits
- Lenient application requirements
- No restrictions on how you spend the funds
- Faster processing and approval
Disadvantages
- Only accessible to businesses that accept credit cards
- Higher rates
7. Business (Corporate or Commercial) Credit Cards
A business credit card is a financing option that lets construction companies make payments with borrowed money. It is used the same way individuals use personal credit cards. It also allows business employees to make payments for all business expenses.
Lending institutions (Banks and Credit Unions) offer business credit cards with access to a certain amount of money every month. The money withdrawn is expected to be paid at the end of the month along with interest. Because business credit cards are not secured or guaranteed, they attract higher interest rates.
Business credit cards are easy to apply for, just like personal credit cards. The application process is fast, and all you'll need is your employee identification number (EIN). And in some cases, they might require a personal credit check, depending on the bank.
Business credit cards are available to businesses of all sizes. They are a good way to separate personal and business expenses for record and tax purposes. They can also help you build your credit score, giving you access to more financing options.
An example of a business credit card is the Toolbox credit card. With this corporate card, you can save money on processing fees and enjoy 12-hour funding.
Benefits
- Easy access to funds
- Helps to build business credit
- Additional perks such as cash backs
Disadvantages
- High-interest rates
- It affects personal credit in some cases
- No purchase protection
Final thoughts
Whether new or old, big or small, every construction business will, at one point or the other, need a loan.
Construction loans help you complete your projects right on schedule and, at the same time, improve your cash flow. Depending on your construction needs, you can get funding through the different financing means listed above.
Construction loans do not cover all expenses. Usually, the lender determines the expenses a construction loan covers. Therefore ensure you get loans under favorable terms.
In addition, endeavor to read the terms attached to the different construction loans and pay them back on time. You would not want to ruin your credit score.
The variety of financing options might confuse you about which program to choose.
We discussed several of these alternatives, and the one that stood out the most was the Toolbox corporate card.
A funding option tailor-made for contractors and construction companies, it is an alternative that understands your plight like no other.
Besides being just a source of funding, you can also use the platform to track and manage your spending on the field. Moreover, there are no sign-up fees, and you can get started for free.
