Construction loans are those that are taken out by real estate developers for the purpose of project financing. Unlike most types of loans, the entire principal is usually due after the construction of the project is complete. The interest rate on such loans is often variable and tied to an index, such as the prime rate.
How Construction Loans Work
Construction loans do not work like your typical loans, such as mortgages or personal loans. When you take out a construction loan, you owe only the interest on the outstanding balance while your construction project is underway. After your project is completed, you owe the outstanding balance of the loan in one single payment. For this reason, construction loans are typically taken out by real estate developers. It is anticipated that the building will be sold upon completion. When a bank approves a real estate loan, they tend to require a feasibility analysis of the project so they are certain that they will get their money back.
The interest rates of construction loans are usually variable. That is, they will change during the time the loan is outstanding. This interest rate is usually anchored to another, standard rate. Many of them are tied to the prime rate, which is a type of benchmark reported by the Wall Street Journal. The prime rate is determined using a survey of the current lending rates in the banking industry. On top of the prime rate, there will usually be a "spread," that is, an additional percentage. The spread may either be variable or fixed, but because the prime rate is variable, the overall interest rate on construction loans are also variable.
Determining the Interest Rate
A number of factors are used to determine the spread on a construction loan. A schedule of construction is drawn up and presented to the lender. Funds are disbursed in segments based on this construction schedule, and any interest is based on funds already disbursed. The spread is then determined based on the lender's opinion on the borrower's ability to pay. If the borrower already has some amount of collateral, then this may be used as a guarantee to obtain a lower rate. If the borrower has little collateral, or if the project is deemed to be of higher risk, then the lender may set a higher spread in order to compensate for this additional risk.
Current Interest Rates
As of July 2011, the current Wall Street Journal prime rate was 3.25 percent, which was the same rate one month before and one year before. Thus, the prime rate was relatively static during this time period. However, this does not include the spread, which may be a few percentage points above the prime rate. The exact spread depends on both the borrower and the financier. If the project is deemed to be higher risk, or if the borrower has little collateral, then the spread is higher. Alternatively, if the lender feels that real estate development is a relatively poor investment, it may also decide to increase this spread. Furthermore, the spread on a single loan may vary.