Summer is here, which means that construction companies are getting ready to break ground all over the country—if they haven’t already.
As construction business owners know all too well, cash can seem to evaporate once a project is underway. Maybe you underestimate the cost of a project, maybe you have to rent or buy expensive construction equipment, or maybe you need to procure costly materials only to have to wait around for weeks to get reimbursed.
Whatever the case may be, it can be tricky for construction business owners to find the funds needed to ensure projects stay on schedule, keep staff happy, and pursue new opportunities.
Instead of letting cash shortages potentially knock projects off-track, many proactive construction business owners look to outside sources of financing to get the money they need to bridge cash gaps, satisfy their customers, and continue growing their operations.
One of the most common sources of financing for entrepreneurs in this situation is called a construction loan.
What are construction loans?
Like the name suggests, you can use the funds from construction loans for—you guessed it—financing residential and commercial construction projects.
Typically, banks give construction business owners short-term loans to finance land acquisition costs and home and building construction expenses. Terms usually last about a year—just long enough for a construction project to be completed.
Generally speaking, there are three different kinds of construction loans:
- You can use a construction mortgage loan to buy land or build a home on land you already own. Typically, lenders release payments in a series of “draws” instead of giving borrowers the full amount of the loan in one lump sum. Interest accrues on the money that you use—not necessarily the entire loan if projects come in under budget.
- A construction-to-permanent loan combines two kinds of loans—a construction loan and a traditional mortgage—into a single financial vehicle. After construction is complete, the loan converts to a standard 15- or 30-year mortgage. The upside, here, is that borrowers don’t have to apply for two separate loans—and therefore don’t have to incur twice the amount of closing costs.
- You can use a commercial construction loan to construct office buildings, multi-family homes, apartment complexes, retail centers, municipal buildings, and more. Banks, being risk-averse, typically expect developers themselves to foot most of the bill for these enormous projects—up to 90%, in many cases. If you’re eying a project like this, don’t expect the bank to finance the bulk of it. You’ll have to come up with most of the cash yourself.
Now that you’re familiar with the various types of construction loans, let’s turn our attention toward the advantages and disadvantages of this type of business financing.
The Pros and Cons of Construction Loans
Like other kinds of financing, construction loans have their pros and cons. Here are three reasons why construction business owners turn to these financial vehicles—and three reasons why they look elsewhere.
Pro #1: Construction loans are flexible
You can use construction loans in a variety of ways—as long as those ways relate to the project you’re seeking financing for. You can use a construction loan to buy or rent new equipment, hire additional workers for an important job, open a new facility or remodel an existing one, get materials and supplies needed for a project, and more.
Pro #2: Construction loans improve cash flow
Once you’re approved for a construction loan, cash flow management is that much easier. This is a big deal because a recent survey revealed that nearly 20% of construction companies have constant cash flow problems, and 66% of them have cash flow problems at least once a quarter.
Instead of wondering how you’re going to make payroll or how you can afford to pay your suppliers, you can focus on doing your best work and delighting your customers.
Pro #3: Construction loans help you finance projects
With cash on hand, you can move projects forward that you otherwise might have had to turn down due to financial struggles. This enables you to grow your business by pursuing opportunities you otherwise wouldn’t be able to afford.
Con #1: Construction loans are hard to secure
Banks are typically wary of financing construction projects. There’s so much that can go wrong, so these types of loans are often thought of as risky. That’s not to say banks never finance construction projects; quite the contrary. They are just quite picky about which businesses to lend to.
In most instances, they prefer lending to businesses that have strong credit scores, great financials, a track record of success, and a solid reputation. Even if that sounds like you, construction loans can also take a long time to come through. It’s not uncommon for borrowers to wait 90 days for funds to finally be available.
Con #2: Construction loans don’t cover all your expenses
In most cases, lenders will ask you to put down at least 20% of the cost of the project up front. If you’re trying to finance a $5 million project, for example, most lenders will expect you to have invested at least $1 million of your own money to get started. If you don’t have access to that much capital, you won’t be able to work on the project.
Con #3: Construction loans can be expensive
Due to the inherent risks in this line of work, construction loans tend to have high interest rates. Unless you have deep pockets, you may want to look for other forms of financing that are more cost-effective.
While construction loans can help some business owners successfully finance their projects and grow their operations, this type of funding isn’t for everyone.
With that in mind, let’s briefly explore some alternatives to construction loan financing.
3 Alternatives to Construction Loans
You’ve decided that construction loans, while interesting, probably aren’t the best bet for your specific situation. What other kinds of loans are available to people like you? Let’s take a look at three popular options.
1. Construction factoring
How quickly do your customers pay your invoices?
If you’re like many other construction companies, it might take a while. Recent research suggests that many of construction businesses (30%) don’t get paid until 30 days after they’ve completed a project. Some companies say it takes 60 and even 90 days for checks to come in.
If you find yourself in a similar situation—and you have lots of unpaid invoices piling up—construction factoring may be an option worth looking into. Essentially, this form of financing involves selling your outstanding receivables to a factoring company in exchange for a portion of the invoice amount.
This form of financing is relatively easy to qualify for and you get immediate cash. But the factoring company (also called a “factor”) collects payments directly from your customers and takes a significant slice of your revenue. It’s up to you whether you’re comfortable handing over control of your customer communications this way.
2. Lines of credit
If you have the bulk of your project financing costs covered and you are simply looking for a little bit of cash to cover miscellaneous expenses as they pop up, a line of credit may be the ideal financial option for you.
Let’s say you get an approved application for a $100,000 line of credit. Essentially, this means you’ll now have access to that much money when you need it—and you’ll only have to pay interest on what you spend. Think of a line of credit like a credit card. The money is there if you need it, and as long as you repay what you’ve borrowed each month, you’ll have access to the full credit line.
Credit lines are flexible—you can use them for almost any business purpose. The application process doesn’t take forever, either. Thanks to new fintech firms like Fundbox, you can apply for a credit line in just a few minutes and find out whether you’re approved later that same day.
3. Loans from the Small Business Administration
The Small Business Administration (SBA) is a government agency that lends money to all kinds of small businesses, including construction companies. The SBA offers a variety of different financing options, but 7(a) loans and 504 loans are probably the best fit for construction companies. While 7(a) loans can fund businesses up to $2 million, 504 loans are usually given to companies that have to make large capital expenditures (e.g., buying machinery, equipment, or property).
SBA loans, however, are notoriously hard to get. Unless you have impeccable financials and a great credit score—and you’re willing to endure a process that can last 90 days or even more—you may want to look elsewhere for financing. Even if you do have spotless credit and think you will qualify, you may not want to wait that long.
Every business is different. While a construction loan might work perfectly for one company, a line of credit might be the best option for another.
Do your due diligence and assess your options. Take your time and you’ll find the perfect financing solution you need to continue building beautiful structures and improving people’s lives.
The SmallBizRising Blog is designed to be an educational content hub pulling information, best practices and practical advice for the small business owner and features topics including accounting, marketing, technology and more. Be sure to subscribe to stay up to date with new content as it is posted. The blog was created by The Neat Company and receives contributed content from a group of contributing companies that provide technology, services and solutions to small businesses.