A construction loan is a form of loan that is used for a construction project. Construction loans are a short-term financial product, designed for people looking to build or renovate a property.
During the construction or renovation process, the costs of building a property can easily stack up over time, with charges incurred at every stage. From land purchase, labour cost, materials and permits, it is difficult to plan for every potential circumstance.
To avoid progress halting, a short-term construction loan can help to bridge the gap, allowing the building project to progress smoothly. Typically disbursed in stages, construction finance is often aligned with the project milestones.
If you are based in the UK, then there is the Help to Build: Equity loan, which is a form of government-backed loan which can cover part of the costs for a construction project, or hiring someone in the project.
We can also advise you at Rise Funding on any kind of loan you might need with our instant quote.
What is a construction loan?
A construction loan or construction finance could be any form of loan that is used for a construction project. There are also several forms of loans built specifically for construction, such as construction-to-permanent loans, as well as owner-builder construction loans.
These loans will often be paid out in instalments known as ‘drawdowns’, which are given as the project progresses, in part to protect the lender. A benefit to the borrower is that interest is only charged on the amount that has been drawn down.
What is a construction-to-permanent loan?
A construction-to-permanent loan is a way of financing the construction of a property. The way a construction to permanent loan works is that it will begin as a loan, but then convert into a mortgage once the construction of the property is complete. This is the most common structure of a construction loan.
What is an owner-builder construction loan?
An owner-builder construction loan is a variant of a construction loan where you are positioned as your own contractor.
These loans are not via a licensed builder, so the interest rates will be higher, and therefore a greater risk for the borrower. This type of construction loan should only be taken with precaution.
Main pain points for construction companies
Construction can be a difficult business, and there are several common pain points for construction companies that can be alleviated with construction loans. There are also many other loans such as invoice financing and cash flow funding which could be used by construction companies to alleviate some of these pain points.
Unpaid invoices
A huge and unfortunately common pain point for construction companies, and in fact many companies, is the issue of unpaid invoices. Getting paid late can cause a real spanner in the works, and disrupt the flow of business, as this might result in a knock-on effect with being unable to pay other suppliers.
A small number of projects
Due to the sheer size of the projects, construction companies might only have one or two projects on the go, which if they fall through, can create a tricky financial situation.
It can be difficult to know your clients’ creditworthiness, so often construction companies can’t always take on new clients easily. Having several projects at once is advised, so that if one falls through, you have something else to fall back on.
If you are looking for a loan to perhaps smooth over any financial difficulties, or potentially rocky periods to come, then you can get an instant quote from us and see if we might be able to help.
Who uses construction loans?
There are many different scenarios in which a construction loan may be used. For example, individuals or families looking to build their own home from scratch may require a construction loan, or existing homeowners undertaking a significant renovation to their property.
Property developers and investors use construction loans when they need to fund land acquisition, materials, labour or any other construction-related costs. Businesses constructing offices, warehouses or retail outlets often use construction loans to finance these projects.
A specialist case is that of ‘owner-builders’, where a licensed builder wishes to construct their own home, getting a loan provided they meet lender qualifications and have a clear building plan. However, as mentioned earlier, owner-builder loans are riskier and harder to obtain.
What are the main differences between a construction loan and a traditional mortgage?
Construction loans have a number of fundamentally different characteristics to mortgages, including:
Purpose
Construction loans are purely issued for constructing or renovating a property, to cover costs associated with this process like land, labour, materials and permits. On the other hand, traditional mortgages are only used in purchasing completed properties, long-term and geared towards property ownership.
Loan Terms
While construction loans typically last between 6 months to a few years depending on the project duration, mortgages generally span 15 to 30 years.
Interest Rates
Due to the increased risk of building projects failing, construction loans have typically higher interest rates. As mortgages are secured by an existing property, lender risk is reduced, allowing a lower interest rate to be offered.
Payment Structure
Construction loans allow for interest-only payments during the building process. Once the project has been completed, this is normally when the principal sum will be due, or converted into a mortgage. On the other hand, traditional mortgages require regular payments that most commonly include both the principal and interest over the loan term.
Fund Disbursement
As mentioned in the introduction, construction loans are tied to certain project milestones. As these milestones are passed, this unlocks further disbursement of the construction loan. Construction milestones are often stages like foundation completion or framing. With a traditional mortgage, the entire loan amount is disbursed upfront, allowing for immediate purchase of a property.
Collateral Requirement
While traditional mortgages are secured by the property itself, construction loans often require personal guarantees. While the loan can be secured by the land and any completed construction, the higher risk often leads lenders to ask for more collateral.
Approval Process
Construction loans will typically require detailed project plans, budgets and timelines, in addition to the usual credit checks and income verification. Traditional mortgages are focused primarily on the borrower’s credit history, stability of income and the value of the property being purchased.
What are the typical interest rates for construction loans?
In early 2025, typical rates for construction loans in the UK range between 4% and 12% depending on the type of loan, the profile of the borrower and market conditions.
Here are some examples:
- Development Finance Loans: typically offering interest rates of 0.33% to 1% per month, giving an annual rate of approximately 4% to 12%.
- Specialist Construction Loans: For bespoke constructions, specialist construction loans can start at around 6.5% annually.
These rates are typically higher than traditional mortgages, due to their short-term nature and the associated risks of incomplete building projects.
Costs of Construction Loans
Here are the main costs of using a construction loan:
Higher Interest Rate
Compared to traditional mortgages, the 4% to 12% interest rates of a construction loan are considerably higher than the typical rates of fixed-rate UK mortgages.
Upfront Fees
Borrowers often incur additional costs like application fees, origination fees and inspection fees for the constant monitoring required during the construction process.
Short Terms
The typical 6-24 month construction loan terms often will force borrowers into mortgage conversion, which can add complexity and cost.
Drawdown Cost
While interest is charged only on funds drawn during the construction process, this can still result in a fluctuating monthly payment as the project continues.
Stricter Requirement
A lender will most likely require detailed plans, budgets and timelines, and want to regularly inspect the progress of construction – increasing administrative costs and building delays.
Benefits of Construction Loans
The main benefits of construction loans are as follows:
Flexible Funding
As funds are disbursed according to the stages of the project, this ensures borrowers have access to capital only once it is needed, allowing costs to be controlled.
Interest-Only Payment
The requirement to only pay interest on the amount drawn can reduce the financial strain on the borrower until the project is complete.
Potential for Increased Property Value
Renovating a property can give a significant boost to its value, increasing equity which can be leveraged in the future.
Potential Easy Mortgage Transition
Many construction loans offer a simplified conversion into a mortgage on property completion.
Tax Benefits for Businesses
Contractors and developers can deduct interest expenses from their taxable income, or qualify for tax credits on energy-efficient or historic preservation projects.
Conclusion
Construction loans have an important function for those looking to finance building projects, to avoid unwanted disruptions to the construction process. Despite higher interest rates and stricter requirements than a traditional mortgage, the flexible disbursement structure and interest-only payment options make the construction loan a valuable financial tool.
If you are looking for a loan to help fund your construction project, Rise Funding can help you find the best option for your business. Whether it’s a business loan, construction loan or others, we’re here to help you make a decision with confidence.
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