Should You Avoid Construction Loans? Here’s How They Work

Construction is one of the oldest industries, serving a basic human need. But that doesn’t make it an easy industry to crack. Many construction companies struggle to get off the ground or to maintain their success once they do. Considering that more businesses are asking their employees to work from home post-COVID, it is even more difficult for a fledgling construction company to succeed.

One of the big struggles construction companies face is cash flow. Building can get very expensive and many clients will only pay once the job is completed. Big corporations have the capital as well as borrowing power to cover the costs. Many smaller businesses cannot keep up.

This is where construction loans come in. More companies are choosing to take out private construction loans. Is this a good idea, considering high interest rates and the tough economic climate?

How does a construction loan work?

Construction loans are loans that are given to specifically cover the costs of a certain building project. The loan makes it possible for the construction company to complete the project. When the client pays, the amount that covers building expenses is used to pay the loan.

In other words, the purpose of a construction loan is solely to cover cash flow issues while the project is being completed. A construction loan is therefore provided with a relatively short term – usually around a year – to provide cover until payment is in.

What does a construction loan cost?

The general rule with short term loans is that they come with high interest rates, making them worthwhile to the lender. This applies here, as even the best construction loans are designed to carry high interest rates.

In the US, with relatively low regulation, private lenders can charge as much in interest as they like. If your credit score is poor or you don’t have any security, the interest is going to be particularly high. Ideally, this shouldn’t make too much of a difference, as you will pay the loan back fairly quickly.

Unfortunately, things don’t always go according to plan. Interest can add up very quickly if you are unable to pay off the loan in the agreed term, and you can get stuck racking up major debt.

Does this mean you should avoid construction loans?

Risky business

All business ventures come with a certain amount of risk. Even if you’re not pouring capital into your new business, you are investing time and energy. There is always a chance that the business is not going to work out and you will be left with nothing or paying back debt.

However, the construction industry carries a very particular type of risk. You are spending big sums of money to carry out the job. If you cannot afford the construction materials, as well as the cost of labor, you simply cannot complete the project.

Furthermore, even if you do have the money to complete the project, you have to rely on the individual or business that contracted your services to remain solvent. If they go bankrupt while you are still working on their project, you may struggle to claim the money back.

There is a lot to lose, in terms of construction materials, salaries, and days, weeks, or even months. Maybe the question is whether you should avoid the construction industry!

Of course, there is a reason you and many other companies are hustling in the construction industry. There is big money in construction. One major project can account for a whole year’s earnings, and if you get contracts from some of the biggest corporations, you could be set for life.

While big construction companies obviously have a lot of pull, there are still plenty of smaller construction companies making big money. More than a trillions dollars is poured into construction in the US alone every single year. It is definitely worth going for if you know you have what it takes to succeed.

Success might just require you to consider construction loans.

Business financing

The ability to source financing is at the foundation of every single successful business. Very few individuals or groups are lucky enough to have enough liquid capital to get their business started. And while many consider VC or angel investment to be the holy grail of business financing, most companies have to settle for loans, whether from banks or private lenders.

When it comes to construction financing, there are few options available. Even if you are able to find an investor to get your company off the ground, they are unlikely to cover the costs of a client’s construction.

For this reason, construction loans are necessary for most fledgling companies. The high interest rates are unavoidable, but can be rendered irrelevant if your project is successful and your client pays.

The key isn’t to avoid construction financing. Rather, it is to take on the projects that are most likely to succeed. You need to be discerning in which clients you choose to work with. While a company with lots of money to throw around may seem like the safest bet, you need to make sure that they are responsible with that money and are not going to go into the project half-heartedly. In the same vein, a company that is fully committed to a vision is going to disappoint you if that vision is not lucrative.

Getting construction finance

As a construction business, you are going to have to contend with high-interest short-term construction loans. These will pay for the materials and your employees’ labor. If all goes well, you will be able to pay the loan back promptly, never having spent too much on interest.

Be careful when choosing your projects. Construction is an industry that requires strict practicality much of the time, as you have to pour money into expensive buildings. Be discerning and always consider your options.