Construction loan

A construction loan pays for building a project. Unlike a home mortgage, it is not advanced all at once. The lender approves a total commitment, and the developer draws on it monthly as the contractor submits invoices for completed work, usually after an inspector confirms progress. Interest accrues on the amount drawn, not on the full commitment.

Construction loans are typically interest-only, carry a floating rate tied to a benchmark plus a margin, and run for the construction period plus some time for lease-up, often two to four years in total. They are sized by loan-to-cost, since there is no finished building to appraise. Lenders usually require the developer's equity to go in first, before the first loan draw, and require a guaranty that the building will be completed.

Interest during construction is itself a project cost. It is estimated in advance and included in the budget as a soft cost or a separate financing line. Because the balance grows as construction proceeds, a delay late in the project is especially expensive: interest is accruing on a nearly full loan while no rent is coming in.

When the building is complete and leased to a stable occupancy, the construction loan is repaid, usually by a permanent loan or a sale. The risk that permanent financing will be more expensive or less available than expected when that moment arrives is one of the main risks a developer carries, and one of the reasons interest rate changes affect what gets built.