Securing the funds to finance construction projects is one of the hardest challenges for construction businesses. In an industry where cash can be tight and profit margins can be low, managing finances is not a simple matter. Fortunately, there are a lot of financing options available to contractors and material suppliers to fund their business ventures. However, different business circumstances means that one type of financing is a better choice than another.
In this article, we take a look at the different types of financing available to contractors and their typical terms and requirements. We will also identify the advantages and disadvantages that you need to consider when choosing the best option for your situation.
1. Business Line of Credit
A business line of credit is an arrangement between a financial institution, typically a bank, and your business that lets you borrow up to a specified maximum amount. Think of it as something similar to a credit card.
Your business withdraws funds within the limit and interest is applied to the withdrawn funds. When the withdrawn amount is paid, your business gains access back to the full credit limit. You can keep on withdrawing and repaying all you like as long as you make the required payments and don’t exceed the credit limit.
How to qualify
To qualify for a business line of credit, you need to fulfill specific requirements set by the financial institution. Banks will take a look at your personal credit score, bank account information, and your business financial statements. They will also assess the market value, risk, and profitability of your business and use them as the basis for the line of credit they will extend to you.
Interest rate: 5% to more than 20%
Ideal for: Small businesses looking for loan flexibility
Pros
- You have flexibility and control over your funds. With a business line of credit, you can tailor your spending based on your business needs and only owe interest based on the withdrawn amount, not the entire credit.
- You gain control over the impact of the monthly repayments on your cash flow. You may pay the withdrawn amount in full or pay a smaller amount as long as you meet the minimum required payment.
Cons
- The lender has the right to reduce your credit limit or cancel the line of credit anytime. When this happens, it may cause cash flow issues, especially if you depend on credit for some aspects of your business.
- Carrying an outstanding balance can incur high-interest payments that can further build up if not paid immediately.
2. SBA Loans
SBA loans are small business loans guaranteed by the Small Business Administration and issued by approved lenders, usually banks. The SBA guarantee partially eliminates the risk for the financial institution issuing the credit. SBA loans can range from as little as $500 up to $5.5 million with an annual percentage rate (APR) that can go as low as 6.5%. Repayment years range from 5 up to 25 years, but the standard is 10 years.
Here are the most popular types of SBA loans:
- SBA 7(a) loan. These general-purpose loans can go up to a maximum of $5 million with a maximum guarantee of no more than 85% of the loan amount from the SBA. The loan term lengths of 7(a) loans can go up to 25 years. 7(a) loans can be used in a wide range of business purposes, including buying real estate, equipment, and another business, and refinancing debts.
Interest rate: market prime rate plus 2.25%
- SBA 504 loan. These loans offer up to $20 million that can be used to purchase fixed assets, usually commercial real estate and equipment. The bank or direct lender extends around 50% of the loan amount, an SBA-approved certified development company provides about 40% of the funds, and the remaining 10% to 15% is a downpayment from the borrower. Loan terms are usually 10 to 25 years.
Interest rate: 3.72% to 7.145%
- SBA express loan. These loans feature fast credit decisions from the SBA in 24-36 hours. For comparison, non-express SBA loans usually take 5 to 10 business days. The standard SBA Express Loan Program offers loans up to $350,000 with a maturity of 7 years for lines of credit, 25 years for real estate, and 5 to 10 years for others. Meanwhile, the SBA Export Express Loan Program offers a maximum loan of $500,000 with the same loan terms as the standard express loan.
Interest rate: prime rate plus 4.5% to 6.5%
Ideal for: Small businesses looking to buy equipment or refinance debt
How to Qualify
SBA loans, as the name implies, are some of the best types of financing for small businesses because of the terms and conditions specifically geared for them. However, qualifying for an SBA loan can be difficult. Certain types of companies are not eligible for SBA loans. These include non-profits, lending businesses, life insurance companies, those that are primarily engaged in political lobbying and gambling, and speculative businesses.
You should also have at least two years in business, although startups can get SBA 7(a) loans with additional requirements that include business and industry experience. Some types of SBA loans may also need a down payment and collateral.
Pros
- The guarantee from the SBA helps small businesses and startups get loans from lenders who may not even consider working with them in the first place.
- The longer loan maturity compared to other business loans helps businesses improve their cash flow.
- Down payments for some types of SBA loans are also lower than a typical business loan.
Cons
- Small businesses and startups need to go through a lot of hoops to qualify for an SBA loan. Your personal credit score is a huge factor in getting a loan. The SBA also requires the personal guarantee of the business owner before they approve the loan.
3. Short-Term Loans
Short-term loans are loans that are scheduled to be paid within one to three years. This type of loan is suitable for small businesses and startups that are not yet eligible for a business line of credit or qualified for other types of business loans. The interest rates and the maximum amount that you can borrow vary across multiple lenders. However, the loan amount is usually smaller, and the interest rates are higher compared to standard loans.
Interest rate: 8% to 13%
Ideal for: Businesses looking to meet unexpected financial needs
How to Qualify
Because of the emphasis on speed, the application for short term loans is a quick and easy process, usually done online. Lenders can approve the loan as fast as one business day after the application. You may be required to provide your credit score, bank statements, proof of ownership, and personal tax returns.
Pros
- Short-term loans have an easier approval process than other business loans. Short-term loans are the best option if you need extra working capital to meet an unexpected need, such as when you need to cover some expenses while waiting for your invoices to be filled.
Cons
- The speed of application for short-term loans is risky for lenders as they do not spend a lot of time vetting customers. For this reason, the interest rates for short term loans tend to be higher than other types of financing. They may also require frequent payments, usually made every week.
4. Merchant Cash Advance
A merchant cash advance (MCA) is a form of financing where a lending company gives you an advance payment in exchange for a portion of your future sales plus additional fees. It is technically not considered a loan but rather a purchase of future sales. The merchant cash advance provider gives a lump sum amount and pulls funds from your business via your bank account or credit card processing.
Interest rate: 15% to 39% plus monthly fees
Ideal for: Businesses looking to have a quick access to cash
How to Qualify
Merchant cash advance providers usually have standards that are easy to qualify for, even for businesses with a low credit score or little to no collateral. Since merchant cash advances are generally paid back with debit and credit card sales, MCA providers will look at your credit card and bank statements to check if you have enough sales volume.
Pros
- Compared to traditional bank loans, merchant cash advance providers do not require high credit scores or collateral. If you apply online and get approved, you can have the funds in your bank account in as fast as 24 to 48 hours.
Cons
- There’s a reduction of cash flow due to the daily deduction of sales receipts. This is especially difficult to deal with for construction companies since payment issues happen far too often in the industry.
- Lenders can impose high interest rates and steep daily payments because the merchant cash advance industry is a largely unregulated market.
5. Business Term Loan
When people talk about the traditional business loan, they are most likely referring to the business term loan. It is a lump sum payment that businesses pay back in regular repayments in a fixed term and interest rate. The requirements, rates, and speed of approval vary across business term loan providers. The length of time to repay long term loans ranges from 1 to 5 years, and the repayment interval is typically monthly.
Ideal for: Businesses seeking control and predictability in their loans
How to Qualify
Banks are usually the lenders that provide business term loans. Because of this, the requirements tend to be stricter than other loans with a longer application and approval process. Lenders typically check your credit score, how long you have been in business, annual revenue of your business, as well as your personal and business tax returns. Lenders may also require you to identify an asset as collateral to back the loan.
Pros
- Business term loans are predictable. Business owners know how much payment is due every month, which means they have greater control over their company’s cash flow.
- Regular payment amounts tend to be lower since they are spread over a longer period of time.
Cons
- Business term loan lenders have higher requirements for loan applicants. This is because banks and other lenders assume a significant risk of nonpayment due to the longer payment periods. Startups and businesses with low credit scores will have difficulty qualifying for a business term loan.
- Business term loans impose prepayment penalties. Prepayment penalties are fees for repaying the balance prior to the end of the loan term. This means business term loans aren’t good for covering short-term financing needs.
6. Business Credit Card
A business credit card is a credit card intended for the use of a business rather than the personal use of an individual. This type of credit card provides contractors and business owners with easy access to a line of credit for short-term financing needs. A business credit card is also a good alternative to the traditional business line of credit.
Indeed, a business line of credit and a business credit card are very similar types of financing in the way that business owners can borrow up to a maximum amount and then pay back the amount withdrawn over and over. However, there are several key differences between the two.
First, a business credit card is unsecured by collateral, while a line of credit can both be secured and unsecured. Next, business credit cards come with annual fees, whereas a business line of credit does not. Finally, business credit cards usually have lower credit limits and higher rates than a line of credit.
Ideal for: Businesses looking for loan flexibiity
How to Qualify
The application process for a business credit card is similar to a personal credit card application. However, there are some requirements that are unique to a business credit card application. First, you need to sign a personal guarantee stating that the creditor can hold you responsible if the primary payer, which is your business, is unable to pay its credit card bills. In addition, creditors will also take a look at your personal credit score. You need to meet a certain threshold before they can approve your application. Finally, creditors will consider your annual business revenue to determine the size of your credit limit.
Pros
- Business credit cards are flexible. Businesses without a well-established credit history will have an easier time qualifying for a business credit card than a traditional line of credit or loan.
- Using a credit card makes online purchases and other transactions with other contractors and suppliers easier. Additionally, cardholders receive perks such as discounts for hotel stays and use of the airport VIP lounge during business travels.
Cons
- Business credit cards tend to have higher interest rates than small business loans.
- The required personal guarantee can reflect poorly on your credit history if your business is unable to pay the credit card bill
7. Equipment Financing
Having state-of-the-art equipment can improve your speed in finishing projects and provide a competitive edge against competitors. One of the best ways to acquire such equipment is through equipment financing.
As the name implies, equipment financing is the use of a loan with the intended purpose of purchasing a physical asset for the business. Unlike a traditional loan, which needs to be secured by separate collateral, the asset to be purchased serves as the collateral until the equipment loan is fully paid. The maximum loan amount can go up to 100% of the total price of the equipment. However, most lending institutions will only agree to pay 80% to 90% of the cost.
Interest rate: 8% to 30%
Ideal for: Startups that are yet to establish a good credit score
How to Qualify
Applying for equipment financing is relatively easy compared to other types of loans. Lending institutions will require you to provide your business financial statements as well as your credit score to determine your financial health. The number of years you have been in business and your annual revenue are important factors that lenders also take into consideration. Finally, some lenders will also ask you to provide an equipment quote or documentation.
Pros
- Startups and businesses without a stellar credit score can easily qualify for an equipment loan since the equipment itself serves as collateral. In addition, since construction equipment tends to be expensive, the ability to spread the cost of the purchase through an equipment loan alleviates part of the cash flow issues common in the industry.
Cons
- The loan is restricted to equipment purchases. You can’t use this loan to cover your rent, payroll, and other expenses.
- Interest rates vary wildly, from as little as 8% to as high as 30%
- Since you own the equipment itself, you may end up with obsolete equipment even if you haven’t finished paying the loan in full
8. Commercial Mortgage
A commercial mortgage is a mortgage loan that is secured by a lien on a commercial property, such as an office building, retail center, or manufacturing facility. In simple terms, a lien serves as a guarantee for the repayment of the commercial mortgage loan. If the commercial property owner is unable to pay the loan, the lender will have the right to seize or sell the property to satisfy the loan.
A commercial mortgage is typically used to acquire new commercial properties or redevelop an existing one. Repayment schedules for this type of financing come in two types: intermediate-term (3 years or less) and long-term (5 to 20 years).
The actual interest rate you get depends on the financial health of your business as well as the loan-to-value (LTV) ratio. The LTV ratio is the measure of the value of the loan against the value of the property. For example, say the property you are purchasing costs $100,000. Applying for an $80,000 loan and covering the remaining $20,000 as down payment yields an 80% loan-to-value ratio ($80,000 ÷ $100,000 = .8 or 80%). By increasing your down payment, and therefore lower LTV, the lower the interest rate for your loan.
Interest rate: 3.35% to 6%
Ideal for: Businesses in need of a loan with low interest rates
How to Qualify
When applying for a commercial mortgage, lenders will need you to provide a detailed business plan, including the property that you intend to purchase or redevelop. After all, the commercial property will act as the collateral for the loan. The aforementioned LTV ratio is also a huge factor in whether you qualify for the loan or not. Finally, lenders will also look at your credit score as well as the financial statements and tax returns of your business to determine your creditworthiness.
Pros
- A commercial mortgage usually has a lower interest rate and fixed monthly payments, allowing you to plan your finances with higher certainty
- Monthly mortgage payments will probably not cost you more than what your equivalent rent payment may be. Since you own the property, your equity in the property will grow along with each mortgage payment, which gives you a more solid financial foundation.
Cons
- Raising a deposit to improve the LTV ratio can be difficult, especially for startups and small businesses. Since you own the property, you will shoulder its maintenance and upkeep. Commercial property value tends to rise, but this depends on the location of the property. There is still a chance that the fluctuations in property prices will cause your commercial property to drop in value, which can negatively affect your finances.
9. Accounts Receivable Financing
Accounts receivable financing is a type of asset-based financing in which a lending institution provides a company with a loan that is secured by outstanding invoices. The financing company lends funds up to 100% of the value of the given accounts receivables, although the typical loan amount is 80% to 90% of the value of the outstanding invoices. Lenders will deduct fees based on the amount of time the customer takes to pay the invoice in full.
Ideal for: Small businesses looking to get a quick access to additional cash
How to Qualify
Accounts receivable financing is easier to qualify compared to a traditional business loan. The approval of the loan is based on the quality of your given invoices and not your financial qualifications as a borrower. Since the loan amount and interest rate will be based on your outstanding invoices, lenders will check the credit rating of your clients and the likelihood that they can pay the invoice on time. Other application requirements include being at least 6 months in business and at least $50,000 in annual revenue.
Pros
- Being able to get cash immediately instead of waiting the typical 30 to 60 days for the client to pay helps business owners improve cash flow.
- Since the invoices themselves act as the collateral, businesses with less than stellar credit scores can get approved much more easily than traditional loans.
Cons
- Accounts receivable financing can be more expensive than other short-term financing options like business credit cards and lines of credit.
- You may find it difficult to coordinate with your clients to forward their payment to the financing company. Ultimately, you will be held responsible if the client does not pay.
10. Invoice Factoring
Invoice factoring is a type of business financing that involves selling your outstanding invoices to a financing company for a fraction of their total value, usually around 80% to 90%. Compared to accounts receivable financing, the lending company takes responsibility for the collection and absorbs the loss if the client does not pay. For this reason, invoice factoring tends to be more expensive than accounts receivable financing.
Interest rate: 13% to 60%
Ideal for: Startups without an established credit history
How to Qualify
The application process for invoice factoring shares requirements with accounts receivable financing. Rather than your credit score as a company, the approval of invoice factoring depends on the credit quality of your invoices. Your client must have a good credit history since factoring companies will only finance high-quality invoices that are likely to be paid on their due dates.
Pros
- Similar to accounts receivable financing, invoice factoring is easy to qualify for even for businesses without an established credit history. The invoice serves as the collateral, and the factoring provider will base its approval decision on your customers’ credit history, not yours.
- The responsibility to collect the receivables falls on the factoring provider. This saves you the headache of tracking down clients in case of delinquencies.
Cons
- Invoice factoring can be costly compared to other types of financing. Since the factoring provider assumes all the risk of your invoices, they will charge you higher fees to take the risk into account.
- The factoring company will interact with your clients to collect the invoice. If they have a negative experience, it may reflect poorly on your relationship.
11. Purchase Order Financing
Procuring materials comprises a significant part of any construction project, and consequently, it also takes a huge chunk from a construction company’s funds. Vendors often require contractors to pay the full amount of materials, especially if there is no prior relationship between you and them. Of course, you can’t start the project and therefore earn income without the necessary materials. To solve this problem, contractors can turn to purchase order financing.
Here’s how purchase order financing works. First, you need to determine the materials needed for the project. Get a quote from your supplier and create a purchase order. Next, the financing company pays the supplier directly for the materials while you pick up the materials. When the project is finished and you have invoiced the customer, the financing company purchases the invoice from you and deducts the vendor payment. Finally, the financing company collects payment from your customer, deducts fees, and sends you the remaining cash.
Interest rate: 1.8% to 6%
Ideal for: Businesses without a stellar credit score and are looking to improve cash flow
How to Qualify
Similar to accounts receivable financing and invoice factoring, qualifying for purchase order financing is easier than traditional types of financing. Financing companies are more interested in the reputation of your vendor and the credit history of your customer than your creditworthiness as a borrower. However, some financing companies may require you to meet a minimum purchase order usually at $20,000.
Pros
- Purchase order financing allows construction businesses to stay competitive even if they don’t have enough liquidity or working capital. There is no need to turn down projects and stop bids because of material supply constraints.
- Purchase order financing is easy to qualify for, even for businesses without stellar credit scores.
- Unlike traditional loans, purchase order financing does not require monthly payments, making it a good option to improve cash flow.
Cons
- While you don’t need an established credit history to qualify for purchase order financing, your clients do need to have good credit scores before the financing company approves the funding.
- The application process can also take a lot of time, and you may have to wait two weeks or more for approval.
- Your client will need to pay the financing company directly, which may reflect negatively on your reputation.
The number of financing options available to you can be overwhelming. However, the right choice for your business boils down to your current business needs and situation. You will need to consider your credit history, how long you have been in business, the reputation of your own suppliers and clients, and the reason why you need financing to ultimately choose the best option for your business.
Further reading