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5 Financing Options for Contractors: Construction Loans, Factoring, and more

5 Financing Options for Contractors: Construction Loans, Factoring, and more

June 27, 2019

Financing a construction business can be very tricky for contractors. The risks of dealing with delinquent clients runs high, and sometimes you have to invest on a new project even before you get paid for the previous one. But don’t fret. From construction loans to invoice financing, there are options available to you.

Whether you’re just starting a small business or you already have a big client base, read on to learn more about the five ways you can source funding for your construction company.

construction loans

Construction Loans

Construction loans are short-term loans that are specifically used to fund the construction or renovation of a property.

How do construction loans work?

  •     Apply for a construction loan
  •     Pay the down payment (typically 20% to 25%)
  •     Receiving funding in installments
  •     Pay off loan at project completion or refinance into permanent mortgage

Applying for a construction loan is not an easy process. You have to have a good credit rating, you must submit detailed building plans, and you must have an appraiser assess the value of the planned property, among other requirements.

If you get approved for a construction loan, you must then pay a down payment which is typically worth 20% to 25% of the total project cost. This is a pretty high amount, but you must also keep in mind that the banks are also taking a huge risk when funding a construction business.

 You will then start receiving installment funding from the bank, and you might also have to pay the interest amount while you are doing the construction. You will also deal with regular site visits and inspections from the lender.

Once the project is completed, you may either get another loan to pay off your debt or you may refinance the construction loan into a permanent mortgage.

What are the advantages and disadvantages of taking a construction loan to fund a project?

The biggest advantage for taking a construction loan are the relatively low interest rates that banks offer. Construction loan interest rates are already high, but they can still be considered reasonable compared with the rates that other private lenders offer. 

On the other hand, however, construction loans are also very hard to secure. The approval process takes a long time, so companies who are struggling with getting a steady stream of cash may not want to go through the lengthy application process. 

The requirements for loan applications are also fairly strict. Smaller contractors with no extensive credit history may struggle to get approved. And when they do, the funding they receive must be used in specific ways according to the agreement with the lender.

Small Business Association Loan

The Small Business Association loan — also known as the SBA loan or the SBA 7(a) loan — is a government-guaranteed loan that can be availed by small businesses including qualified construction companies.

How do SBA 7(a) loans work for contractors?

  •     Apply for the SBA 7(a) loan via an affiliated lender
  •     Receive funding and use it to fund construction project
  •     Pay off within a 5- to 10-year term

Applying for the SBA 7(a) loan must be done through a lender that is a partner of the program. There are eligibility requirements that you must meet, and each lender will also offer different rates. Generally your company must qualify as a “small business” under SBA definition and you should also be on good credit standing with respect to government loans.

When you get approved for an SBA 7(a) loan, the government will guarantee part of your loan. The government essentially co-signs the loan with you and will shoulder part of the payment in the event that you default. Interest rates usually run from 10% or higher.

The loan terms also vary, from 5 years to over 10 years, depending on what kind of loan you have. Loans for working capital usually go for 5 to 7 years, while loans for equipment may go for up to 10 years.

What are the advantages and disadvantages of taking an SBA 7(a) loan? 

The terms for SBA 7(a) loans are generally more flexible than a traditional construction loan. Interest rates are also lower because the government acts as guarantor for part of the loan. There are also different types of SBA loans that you can look into, including the SBAExpress loan which has a faster approval time for a smaller amount.

On the flip side, however, the application process can also be pretty stringent. A contractor who handles bigger accounts may not qualify as a “small business.” You will also have to look for the right lender which can offer you the best rates for your needs. Each loan will be different and you may not always get approved for the amount that you requested. 

Contractor Line of Credit

A contractor line of credit is a business line of credit that you apply at a bank institution or a lender that offers it. 

How does a business line of credit work for contractors?

  •     Apply at a finance institution
  •     Gain access to a pool of money
  •     Pay interest only for the money that you spend

Applying for a business line of credit is similar to applying for any line of credit. The lender will access your credit rating and capacity to pay, and once you get approved, you will have access to a pool of money that you can use anytime.

Just like a personal line of credit, a business line of credit will only incur interest once you spend the money. This option, therefore, works as a contingency funding should a financial emergency arises. You may also use this pool for buying materials on an as-needed basis. And if you don’t spend any money from your pool, you don’t have to pay interest.

What are the advantages and disadvantages of a business line of credit? 

Lines of credit follows a pay-as-you-use framework, so that’s a plus. As long as you keep yourself from misusing the funds, you will have a steady source of funding.

 A business line of credit can also balance your business’ cash flow. You may use it to buy materials for your next project, and you may also tap into it when addressing hiccups like broken equipment, etc. 

However, business lines of credit is also difficult to qualify for. You have to have a good credit rating, and some lenders require lots of paperwork including financial statements, business documents, and other information.

Some lenders might also charge hidden fees instead of giving you a high interest rate, so you have to look out for that. Also, the amount ceiling for lines of credit tend to be pretty low. This makes business lines of credit as a good cash flow insurance, but it may not be enough to fund the entirety of a big project.

Equipment Financing

Equipment financing is a type of loan specifically for purchasing heavy equipment or equipment with a high life expectancy rate (e.g. bulldozers, tractors, etc.).

How does equipment financing work for contractors?

  •     Find a vendor from which you will buy the equipment
  •     Apply for an equipment financing through a lender
  •     Buy the equipment which acts as collateral to the loan
  •     Pay over a 2- to 7-year term

Equipment loans are just like any other bank loan, but it is particularly used for buying big equipment like bulldozers, cranes, tractors, etc. Contractors who work on big industrial or commercial projects may want to look into equipment financing since they will be using these heavy duty equipment for a long time.

Before applying for an equipment loan, you must first find the vendor from which you will get your equipment. You then apply to the lender with your and the vendor’s details, and once approved, you can finally buy the equipment and start using it on your project.

The interest rates are usually lower compared to the other construction loans, typically below 10%, and the down payment also usually does not go above 5%. Note that the equipment itself acts as a collateral for your loan, so you may lose it in case you default on the debt. 

What are the advantages and disadvantages of equipment financing?

Compared to other construction-related loans, equipment financing has lesser requirements and has a quicker turnaround regarding approval. However, it is limited only to buying equipment and no other purpose. 

Your payment for the equipment is also tax deductible, which is a good thing, and your payment agreement with the lender can also be flexible. Still, buying equipment through a loan will be more expensive than paying for it in full. Equipment financing is a good option for contractors who need access to equipment but who don’t have the resources to pay for it up front. 

Invoice Financing / Invoice Factoring

Invoice financing and invoice factoring are two ways to get advance payment from a lender for the invoices that your clients are yet to pay.

How do invoice financing and invoice factoring work?

In invoice financing, you:

  •     Use your unpaid invoices as proof of financial capacity to pay off a loan;
  •     Receive a partial amount of the total value of unpaid invoices from the lender;
  •     Pay the lender back once your invoices get paid.

In invoice factoring, you:

  •     Sell your unpaid invoices to the lender;
  •     Receive partial advanced payment from the lender;
  •     Let the lender collect the payment from your clients;
  •     Receive the rest of the payment from the lender, minus the fees.

In both cases, the advanced partial payment can usually go from 60 to 85% of the total value of the unpaid invoices. And instead of waiting for the invoices to get paid, you receive this advanced payment soon as you sign the deal with the lender.

If you are on a long-term agreement with the lender, you will have a steady source of cash even during downtimes when you are transitioning from one project to the next. Fees are also lower when you are engaged on a long-term contract with the lending or factoring company.
Invoice Financing vs Invoice Factoring

What are the advantages and disadvantages of invoice financing and factoring? 

Both options are good sources of cash when you’re on a low budget while waiting for your clients to pay up. Instead of waiting, you balance your cash flow by receiving advance payments from the lender.

On the offside, however, the fees usually run high compared to other loans. Sometimes they go from 5 to 35%, depending not just on your credit rating but also on the credit rating and payment history of your clients.

Also, both invoice financing and invoice factoring only address cash flow hiccups regarding delayed payments. If you are going through a major financial issue, selling your invoices may not necessarily help you.

 Further reading