Hard Money Construction Loans Explained

Hard Money Construction Loans: The Definitive Guide

What is a Private Construction Loan?

A construction loan is a short term loan used to finance the construction of a real estate project. They generally last from 12 to 24 months and are intended to help the builder pay for the construction of their project.

Upon closing, a portion of the loan proceeds are used purchase the property and the remaining balance is held in an escrow account and disbursed to the borrower as the project is constructed (more on that later).

There are two main types of construction loans: loans for the renovation of an existing project (rehab loan) and loans for the ground up construction of a new project. In this article, we will be focusing on loans for new construction.

Who Are Private Construction Loans For?

As with most hard money loans, private construction loans are intended for builders and real estate investors that do not intend to occupy the property as their primary residence once it is complete.

Most often, construction loans are used by experienced builders to quickly and seamlessly finance construction of single family spec homes, apartment buildings, or subdivisions.

Unfortunately, hard money construction loans are not intended to be used by consumers who want to build their dream house. For owner-occupied borrowers, a construction-to-permanent loan might be a more suitable option.

What Types of Construction Projects Qualify?

Ground up Construction loans can be used for all types of construction projects, including residential, commercial or industrial.

They are most often used for construction of single family properties, but they can also be used for condominium projects, multifamily complexes, townhouses, subdivisions, as well as larger commercial projects.

What are the Benefits of a Private Construction Loan?

The three main benefits of private construction lenders are:

  1. Speed to Close
  2. Flexible Underwriting
  3. Asset Based Lending

Whereas traditional lenders require borrowers to go through a long and arduous approval process, private construction loans are asset-based with much less documentation.

Hard money lenders base their approvals on the terms of the deal the borrower’s experience, and the borrower’s credit score.

Borrowers are not required to submit tax returns, proof of employment to qualify or take income ratio into consideration. For this type of loan, the lender will usually only require one or two bank statements to verify the borrower has enough cash to close.

While traditional loans can take 3-5 months to approve a construction loan, private lenders can approve and fund hard money loans in a fraction of the time, usually a couple of weeks, and without all of the paperwork that traditional financing requires. 

How do I qualify for a Hard Money Construction Loan?

Construction loans are intended to finance the construction of a project or “go vertical.” In order to qualify for a construction loan, the property must already be entitled for the type of building that the real estate investor wants to construct.

In order to get approved, the borrower will need to have completed architectural plans, engineering, budgets, and a scope of work. Plans, engineering, and fees are generally referred to as “soft costs” and some lenders will allow the borrower to finance those into the overall loan. 

Hard Money Construction Loans

Once the borrower has the necessary plans and entitlements, they will fill out an application with a hard money lender. In addition to the application, the lender will want to know the borrower’s credit score, any previous experience, and the plans and scope of work for the project.

Based on that information, the lender will then issue a term sheet to the borrower that outlines the loan terms under which the lender is prepared to offer a loan. These terms can vary, but usually range between 70% and 85% LTC (Loan to Cost) based on the overall project budget. This means that the borrower will be responsible for paying closing costs as well as 15% to 30% of the cost of construction.

Once the borrower accepts the terms, the lender will order an appraisal of the property from a licensed appraiser. While the appraiser is conducting the appraisal, the lender collects any outstanding items and makes sure the file is complete. Once the appraisal is compete and approved, the lender will complete the final underwriting and fund the loan.

How Are the Loan Proceeds Disbursed?

During the underwriting phase of the hard money loan, the builder provides the lender with a scope of work and budget that breaks the project down into phases and specifies how much each phase will cost and how long it will take. All of this is determined in the Draw Schedule.

Later, as each phase of construction is complete, the borrower contacts the lender to inform them that a phase has been completed. The lender then orders an inspection by a 3rd party company who visits the property and verifies that the agreed upon work has been completed.

Once the inspection has been completed and the work verified, the lender reimburses the borrower for the outstanding construction costs. The entire draw process usually takes about 3-5 days to complete.

How do the Payments Work?

Although there are many types of loans, it is important to note that this is not like a traditional mortgage where payments are amortized and consist of principal and interest. Hard money loans are generally interest-only, which means that the monthly payment is just the interest due on the loan and does not decrease the overall loan balance.

The payment can either be setup as Dutch, where the borrower pays interest on the full amount of the loan, or non-dutch (also known as “New York Interest”) where the borrower only pays interest on the amount of the loan that is disbursed. When evaluating your financing options, it is important to find a lender that offers non-dutch payment options.

What to look for in a Construction Loan Lender

There are many hard money construction lenders out there. In general, finding a reputable hard money lender is no different than any other business. Check their website to see if they are licensed by their state and the NMLS. Also, see which trade groups and organizations they belong to. The American Association of Private Lenders (AAPL) is a good one to check with.

Private Construction Lenders

Most importantly, work with a lender that you trust. Most private construction lenders will have similar terms, so it really just comes down to working with someone that you feel comfortable will be transparent, honest, and will treat you right.

Take a look at their reviews on Google and Facebook to see what their customers have to say. Try and stay away from private lenders that charge large up front fees before the approve your loan. It is customary for the borrower to pay for the appraisal, but other than that, most lenders do not usually charge any upfront fees just to review your loan.

Is a Hard Money Loan Right for Me?

If you need to borrow money for a ground up construction project and want to avoid the headaches of dealing with big traditional banks, private construction loans can help you raise the cash you need, save you valuable time, and offer flexible terms.

Whether you are building a single house or an entire subdivision, experienced real estate investors know that private financing allows them to focus on building their projects without worrying about red tape, lengthy approvals and endless paperwork.

If you have any additional questions about real estate investing that weren’t covered in this article, please see our FAQ for additional resources and information. You can also learn more about our loan programs or contact us directly for more information.

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