Real estate lending can be complex as there are multiple loan options available. However, the variety allows investors and property developers to choose an appropriate loan depending on the costs of a specific project and available funds. A good understanding of the intrinsic differences and characteristics of available options can help you make a good decision.
Bridge and construction loans are common hard money loans that you can tap into when undertaking a real estate project. Therefore, it’s prudent to understand the differences.
What is a Construction Loan?
Construction loans are often issued against real estate value when funding new projects. Typically, these loans provide the money for purchasing shovel-ready land. It covers the costs of buying the land and building a new property. New construction projects tend to be more expensive than purchasing an existing property.
Most lenders design the loan structure based on construction reserve accounts depending on the property value and potential loan risks. Approximately 10% of the total loan cost is used to cover the costs associated with potential risks.
The defining factor is that construction bridge loans are not disbursed in full when closing the borrowing process. Instead, the funds are released in stages depending on the construction budget. Also, the loan has a pre-funded interest reserve account to issue payments when construction is ongoing. After the construction phase, the loan is paid back with a refinance.
The term and total loan amounts depend on construction cost, but it’s usually between 12 and 24 months. The loan only attracts interest during the construction phase, but it includes a non-material execution risk.
What Is a Bridge Loan?
Bridge loans serve a vital need in the real estate industry for people selling a home to purchase a new one. It is a short-term loan that provides the funds for buying a home before selling your current home. Bridge loans for new construction reduce the hassles of looking for a house when your home is on sale. Since the loans are short-term solutions for home buyers, the loan term is about six months. Also, bridge loans have higher interests than traditional loan options.
The real estate market can be competitive, and buyers need to act quickly once they find a suitable house. To secure a good property, home buyers use a bridge loan in the short term before refinancing with a long-term loan. The typical interest rates depend on the value of the real estate property and the creditworthiness of a borrower, but it’s about 1% higher than conventional loans. A peculiar characteristic of bridge loans is that the borrower uses their current home’s equity when purchasing a new house.
Bridge Loan vs Construction Loan
It can be challenging to distinguish between types of loans that sound similar, like a bridge loan vs construction loan. While they can be categorized as hard money loans and look like they are used for similar needs, the loans have distinct characteristics.
Construction Loans vs Bridge Loans Uses
Typically, retail apartment construction bridge loans are used to purchase a property where new construction will start or an existing building that will be demolished to pave the way for new construction. On the other hand, bridge financing can be used to purchase a construction-ready property, but it can also be used to acquire a property that needs slight home improvements before flipping at a higher amount.
Moreover, bridge loans are a temporary financial solution for individuals who want to buy a property quickly before securing long-term financing or a line of credit.
Construction Loan vs Bridge Loan Repayment
In bridge loans, the amount is paid back using a long-term financing option taken later. On the contrary, borrowers pay back a personal construction loan after completing the construction and selling the property. As such, bridge loans have a shorter repayment time compared to construction loans.
And while the two funding options may seem to overlap, the terms determine how borrowers can use the money. Ideally, bridge financing doesn’t cater to construction costs since its primary use is property acquisition. On the contrary, construction loans are a better option for developers who need money to build a real estate investment property.
When Should You Use a Bridge Loan?
Bridge financing is suitable when you need financing for the short term before you find long-term funding options. The loan comes in handy when you want to acquire a property quickly, especially when dealing with a competitive market. Since mortgage bridge loans are more flexible, an investor can refinance with a long-term home equity loan when all permits and documentation are ready.
Additionally, developers targeting construction-heavy projects for commercial use can leverage a bridge loan to acquire the property. This is because a hard money loan has a 12-month term, making bridge money an appropriate option before getting all the necessary zoning and approvals. After acquiring the property and getting everything in place, it becomes easy to refinance with a less-costly financing option.
A bridge loan is often used to cater to various costs, including:
- The costs of urgent closing costs and deadlines
- Property rezoning
- Soft costs before residential flipping
When Should You Use a Construction Loan?
A construction loan is appropriate when a real estate investor wants to buy a shovel-ready property. The funding takes care of the costs of acquiring the property and starting construction work. In addition, this type of funding can be suitable for a developer who wants to buy a distressed property to tear down and rebuild a new property. Whether it’s a dilapidated property or a mold-laden house, an investor can use a construction loan to buy and remodel the property before selling it at a profit.
A construction loan can be a good option if you already have a property and the necessary permits to begin building new structures. Typically, getting the permits for new construction can be an uphill climb, but if you have the documentation ready, construction financing can provide the money needed to kick start the project. This type of financing can be used to cover various costs, including:
- Cost of buying land
- Building materials
- Contractor expenses
- Construction permits
Bottom Line
The real estate landscape can be complicated if you don’t have sufficient funds to finance your project. But there are several hard money options you can leverage when you want to venture into real estate investment. Bridge loan vs construction loan are among the great funding options for real estate investors and developers.