What’s a Construction Loan Contract?
Whenever a builder or contractor starts on a worksite, there is a verbal agreement with the owner to begin some sort of construction. This oral agreement is fine for smaller jobs, but it falls short on large-scale constructions. That’s where a construction loan contract comes in. These contracts serve the purpose of complying with all construction regulations and state Laws. They don’t only protect the builder, but also the owner of the property. If you are new to construction or want to understand how construction loan contracts work, then here is your guide.
A construction loan contract is essentially an agreement between the owner of the property and the building contractor. The owner of the project hires a contractor to design and/or build a project at a specified price. Any amendments and changes to this contract must be written and a part of the signed agreement. The terms of a construction loan contract will vary based on the type of construction performed , the type of construction loan, price of the project, etc. While it is common for construction loan contracts to be different, everything within a construction loan contract has some commonalities. Here is a general breakdown of a standard construction loan contract: It is essential to understand that the specific terms of a construction loan can change depending upon the contract itself.
If you are building a single family home, then the construction loan contract will be short, sweet, and to the point. However, if you are building a skyscraper, then the construction loan contract will be long and detail-oriented. No matter the scope of the construction or the construction loan contract, it is very important to the success of the project because they are designed to:
Basic Elements of a Construction Loan Agreement
As with any contract, the construction loan agreement should contain key provisions that set out the parties’ expectations and obligations. The provisions discussed below are typical in most construction loan agreements:
Loan Amount
The loan amount is the maximum amount that the lender will provide to the borrower for the construction project. Usually, the loan will not be advanced until the borrower has completed certain preconditions, such as obtaining permits and a municipality’s consent.
Interest Rate
The interest rate is the percentage that the borrower will pay to borrow the money. Construction loan agreements may base the interest rate on the prime rate or other defined index rates. If construction progresses significantly later than anticipated, the lender may require interest rate adjustments. The agreement typically states whether the loan is a fixed-rate or variable-rate loan and whether the lender can assess default interest if the borrower misses a payment.
Disbursement Schedule
Most construction loan agreements have a disbursement schedule which sets out when the lender will advance funds to the borrower. The advancement schedule will usually be subject to the borrower fulfilling certain requirements, including providing the lender with lien waivers and other documentation. Because the disbursement schedule allocates funds to particular parts of the project, it will depend on the construction schedule, which means the owner and the general contractor will need to cooperate to complete the project on time.
Repayment
The construction loan agreement will specify when the borrower must pay back the loan, which is generally at the completion of the project. As with any loan, the borrower must repay the interest until the loan is paid back. Failure to repay the loan in accordance with the agreement will often result in default and the lender seizing collateral. In many cases, construction loan agreements grant lenders a security interest in the land being developed and the improvements. As a result, the lender can sell the property if the borrower defaults.
How to Qualify for a Construction Loan
To qualify for a construction loan, you must have solid income sources as well as sufficient assets. Banks will typically require that you qualify for the entire mortgage amount. Loan amounts are based on loan-to-value ratios or loan-to-cost ratios, and these ratios will be considered during the construction loan review process. Lending services are almost always limited to the home’s value so, under most circumstances, you likely cannot turn to construction financing to turn a profit on the "quick flip" of the house. Most home builders take out a construction loan out on their own house, so having to devote the time necessary to find a property to flip really stands out in this particular instance. A loan-to-cost ratio of 80 percent will be maintained by lenders. This means that you can afford about an 80 percent loan-to-cost ratio on the purchase of the proposed home. To get this money, you must prove that the home will appraise for that amount.
One of the first qualifications for a construction loan is credit, and lenders will review your credit report, including your payment history and your credit score. With a minimum credit score of 620, you are already at a significant advantage. Keep in mind that many lenders will only do a conventional loan if your credit score is a 680 or higher.
It is important to understand that, while timeliness of bill payments does factor in to your credit score, lenders also consider other circumstances that may have affected your credit. For instance, a loss of employment, serious illness, or other natural disaster may affect your credit score, but lenders will also view you as someone who has experienced a hardship and who, therefore, is likely to appreciate the support.
Risks & Disadvantages of Building Construction Loans
The financial backing provided by a construction loan can be disrupted by forces beyond the control of anyone. Modifications to building codes that apply in force only to a specific home could push the budget too high for the original agreement to function. Problems that arise during construction can interrupt the steady cash flow without shutting off the flow of bills from contractors and vendors.
Legal Problems with the Property
Most construction loans include a plot of land that will be improved by a new building. The individual who applies for the construction loan may not have purchased the land, and title or deed problems may arise. If the property changes hands once, a foreclosure may arise over a modification that was not put in writing and recorded. If the land cannot be delivered at the highest value, the loan comes with greater risk. As a result, the nature of the lien securing the loan may change in a way that limits its flexibility.
Cost Overrun and Scheduling Problems
The schedule for the project must allow for a construction loan that will be used in stages. Sprinklers may be bypassed for a few weeks to save costs, and this could delay the project. If materials are ordered twice for a truss that is damaged during testing, the loan must cover the extra costs. The money that is held in escrow must be able to cover delays that were not originally accounted for.
Inability to Comply with Regulations
The original project specifications may be based on an existing code, but if the code changes, the planned construction may be in violation. The space may not meet environmental guidelines, and the funds to bring the property into compliance were never made available. A construction lender may wish to avoid a change order for aesthetic reasons and refuse to lend more money to cover the increased cost. In such a case, the borrower should seek both a construction attorney and air quality specialist to ensure that the right permits have been obtained.
Tips for Negotiating a Construction Loan Contract
When negotiating the terms of a construction loan, the borrower should first make sure he or she has sufficient negotiating leverage with the lender (as opposed to a contractor/subcontractor who has no negotiating leverage with a lender). Then , the borrower should try to negotiate the following provisions so they are as favorable as possible: Construction loan contracts and their provisions can be very complex. The borrower should consult with a construction law expert before signing a construction loan contract. Attorneys can help a borrower determine red flags, negotiate the best possible terms for the borrower, and litigate an issue in court should it arise later.
Legal Issues in a Construction Loan Agreement
The legal considerations in the construction loan contract are vital for the smooth completion of the job and to protect both the bank and the contractor from any misdeeds.
One potential issue may be the legal requirement for permits to be obtained before beginning construction. When this requirement is understood by both parties, it should not be an issue. However, when plans do not call for this as a requirement then an amendment or rider is appropriate.
The contract may also include a provision for the lender to inspect the contractor’s premises to ensure capital invested is being used properly and not for personal expenses. Some workers who are being paid by the contractor may also be using tools and equipment nonchalantly and potentially destroying the property.
A dispute resolution clause is also necessary to avoid conflicts during the loan period. This contract can enable the bank to settle the issue with the contractor. In case of arbitration, the contractor will pay for it but depending upon the relationship between the parties it may be decided that the bank pay for arbitration or that each party pay their respective costs.
Laws vary by state relating to permits, rights of way and the ability for one party to enforce the contract on behalf of another party. For example in New York State if a property is vacant land without a dwelling on it, it can be used by parties who want to enter into a construction contract. If any trespassing occurs or other persons enter the property, damages may be sought from those persons who enter without permission. An easement should also be established for a construction project that requires vehicles to go through other property not involved with the project.
The Role of a Construction Loan Broker
A trusted construction loan broker will help you avoid the worst-case scenario by helping you negotiate the best loan terms for your project, and ultimately reducing the stress of your construction loan experience. This is a rather simplistic description of what a qualified and ethical broker can do for you. The reality is that a construction loan broker does so much more, especially at closing, to ensure success.
Choose An Ethical Broker
To whom should you turn to guide you to the best construction loan? Certainly not a bank or lending institution. Why not? They are going to favor their own best interest in the loan agreement.
Consider this. When you go to your bank for a loan you are essentially asking them to lend you money which means you are requesting their trust. When dealing with a broker, the bank always holds a multi-million dollar interest in the project and broker. They are interested in protecting their investment over yours every time. Why? Because the broker is essentially a contractor for the bank. They are paid big commissions to get development financing for clients. They get little to no "rate cuts" for you . You cannot rely on them for anything other than a loan because they essentially are in business with the banks and lending institutions, not you.
Good Brokers Have Experience
Your broker will know if you are a high risk borrower because they see the same applicants every day. They understand who gets approved, who gets turned down and what the deal was that got the line of credit. A good broker will ask all the right questions to determine if they should present your deal to a lender. If they believe your deal is weak they will tell you. If they are honest and ethical they will tell you how to build strength into a weak deal. In almost all cases the broker will do everything possible to secure a loan for you. They do this by looking at the advantages of the deal then emphasizing the good during the presentation to a lender. They will make sure to put the deal in the best light before the lender.
Hire an ethical broker who has plenty of experience. Conduct some research on them before choosing. Choose someone who has worked with you before and is proven, or ask friends and family for a recommendation.