Before you take out any kind of construction loan to build or renovate a commercial property, you need to understand what the current rates are so you can determine if you’re eligible and how much it will cost.

In this article, we’ll discuss the average interest rates certain kinds of construction loans get, the factors that determine construction loan interest rates, the cost of a construction loan, and construction loan alternatives.

Key Takeaways:

• The average interest rate on most construction loans is between 6% and 8%. If your credit isn’t great and your finances look shaky, expect an interest rate around 10% or more.
• A construction loan’s interest rate is based on your creditworthiness, the loan’s purpose, the term, your down payment, the loan’s size, building-specific factors, your income, and your debt-to-income ratio.

What’s the Average Interest Rate on a Construction Loan?

Construction-to-Permanent Loans

A 10-year construction-to-permanent loan can have a fixed rate as low as 6.750% and an APR as low as 7.033%, whereas 15-year loans can have a fixed rate as low as 6.875% and an APR as low as 7.077%.

The fixed rate on a 20-year and 30-year loan can be as low as 7.375%, but the APR on a 20-year can be as low as 7.540%, whereas 30-year loans can have an APR as low as 7.503%.

The most expensive construction-to-permanent loans, as far as interest rates are concerned, are 30-year jumbo loans; these can have a fixed rate as low as 7.5% and an APR as low as 7.553%.

Construction-Only Loans

A construction-only loan can have an interest rate between 5% and 10%, but the average is about 6%. This interest rate only applies to the funds that are used to construct the property.

After construction is complete, you’ll need a mortgage. The average interest rate is around 7% on a 30-year fixed mortgage while the average interest rate on a 15-year fixed mortgage is around 6.2%.

Owner-Builder Loans

An owner-builder loan can be a construction-permanent loan or a construction-only loan. Therefore, expect an interest rate between 6% and 10%. Owner-builder loans are different from other construction loans because the owner is in charge of building.

The interest rate on one of these loans can be quite high, as there’s more risk on the lender’s end, especially if the loan is for construction only.

Renovation Loans

The average interest rate on a home equity loan is between 6% and 7%, while the average interest rate on a home equity line of credit is between 8% and 10%. It’s important to note that home equity lines of credit tend to have variable interest rates, whereas home equity loans usually have a fixed interest rate.

You could also use a personal loan to cover the costs of home improvement. The average interest rate on a personal loan is 12%.

Factors That Determine Construction Loan Interest Rates

Creditworthiness

Your creditworthiness will play a major role in determining your construction loan’s interest rate. Most lenders consider a score of 670-739 good, whereas 740-499 is very good and 800+ is excellent.

But it’s not just the number that’s important to lenders. They’ll also look at your credit report to see how much debt and available credit you have. If you have more debt than available credit, it’s likely you’ll be saddled with a higher interest rate.

Of course, you could refinance the mortgage part of your construction loan later, if you have good credit, to get a lower interest rate.

Type of Loan

Not all construction loans have the same level of risk, but the riskier ones generally have the highest interest rates.

The risk on a construction-to-permanent loan is minimal because it’s a construction loan and mortgage rolled into one. Construction-only loans are riskier because the borrower may not be able to get a mortgage once construction is complete. The riskiest of all is the owner-builder construction loan because the owner/builder may construct a building that’s rife with code violations and other problems.

Construction loans typically have higher interest rates than regular mortgages because they’re unsecured. If a lender funds a building project that never gets completed, it will be a lot harder for them to recoup their loss since there’s no building to sell.

Term

Construction loans with a 10-, 15-, or 30-year term generally have higher interest rates because there’s more risk to the lender. After all, a lot can happen to a borrower over such a long span. For example, their capacity to earn may shrink or their expenses may rise. In either case, default is more likely.

Also, the risk of early repayment is greater on long-term loans. Of course, early repayment isn’t nearly as bad, for the lender, as default, but it’ll reduce how much the lender makes on the loan. In some cases, prepayment penalties amount to 1%-5% of the loan’s value.

Down Payment

You’ll have to make a down payment to secure any of the construction loans discussed. Construction loan down payments tend to be larger than mortgage down payments because there’s greater risk on the lender’s end. The average construction loan down payment is 20%-30% of the loan’s value.

A down payment doesn’t just reduce the lender’s risk but also shows that the borrower is serious about the commitment they are making. Also, a larger down payment will make monthly repayments smaller and may even get you an interest rate closer to 6%.

Size

Like the term, the loan’s size has a hand in determining your interest rate. Larger loans are riskier, so lenders charge higher rates of interest to account for the elevated risk. Also, since the repayments on large loans are sizable, borrowers are at greater risk of defaulting.

A positive aspect is you’ll only have to make interest payments during the construction phase. And if you get a construction-to-permanent loan, you’ll only have to pay one set of closing costs. This is the main reason why these loans are cheaper than construction-only loans.

Type of Property and Location

The type of building you’re looking to construct is an important factor too, as is the location. Some locations are more expensive than others, so there’s more risk to the lender if the building doesn’t go up as planned.

Also, lenders will have to take resale value into account, as they may have to seize and sell the property if you default. Of course, they don’t want to finance a building that isn’t worth what was spent to construct it. To ensure this doesn’t happen, they make sure appraisers and home inspectors are involved in the construction process.

For this reason, many lenders are adverse to writing owner-builder loans. If the owner is in charge of construction, the lender essentially has to trust that the owner/builder has the know-how and experience required to make sure everything is up to code.

Income

How much income you bring in on a monthly or annual basis plays a role as well. Basically, if you’re only bringing in enough to cover the cost of repayments, it’ll be hard to secure financing. That’s because lenders will assume any reduction in your earning power will prevent you from making repayments on time.

Usually, lenders want to see that you make two or three times more than what you’d pay in repayments on a monthly basis.

Debt-To-Income Ratio

Your debt-to-income ratio is key because it’ll show how much of your income goes to servicing debt. A DTI of 36% or less is considered good because most of your income is being saved, invested, or used for another purpose. Conversely, a DTI above 50% is considered a red flag because most of your income is going toward servicing your debt.

Do Construction Loans Have Fixed or Variable Interest Rates?

Construction loans can have fixed or variable interest rates. If your construction loan’s interest rate is fixed, it’ll be the same rate throughout the lifetime of the loan. If it’s a variable rate, it will go up and down throughout the lifetime of the loan.

Variable-rate construction loans can be cheaper or more expensive than fixed-rate loans. Especially if you get a variable-rate loan at the end of a period of low rates, you’ll probably pay more in the long run than you would have if you got a fixed-rate loan with a low interest rate.

How Much Does a Construction Loan Cost?

The cost of a construction loan is determined by the interest rate, fees, the loan’s term, and the loan’s size. Regarding fees, you’ll often have to pay an origination fee, home inspection fees, appraisal fees, attorney fees, and a handful of other fees.

Of course, larger loans with a high interest rate and long term will cost more than small loans with a low interest rate and short term.

For example, a 10-year, $400,000 construction loan with an 8% interest rate will cost about $582,372. Monthly repayments would be around $4,853 and total interest over the lifetime of the loan would amount to $182,372.

A 5-year, $200,000 construction loan with a 6% interest rate will cost about $231,993, meaning you’d pay $31,993 to borrow the lender’s money.

Construction Loan Alternatives

Term Loan

Most businesses get a conventional term loan when they need financing. These are different from construction loans in that you get a lump sum up front. With a construction loan, you draw on your credit line as construction progresses.

A conventional term loan can be for hundreds of thousands or millions of dollars, and the average interest rate on one of these loans is around 9%. Usually the term is 10-30 years, and in most cases it takes 7-14 days to secure financing with a term loan

Many businesses get a term loan from a traditional lender, but you can get one from an online lender like Llama Loan to secure the best rates and terms possible.

If you have good credit and solid business finances, you should be able to secure a lower interest rate and flexible repayment terms.

You’ll also have to put up collateral worth 80%-100% or more of the loan’s value. Real estate, vehicles, and collectibles are all examples of acceptable collateral. However, any collateral you put up has to be appraised before it’s accepted. You’ll also need to put down a down payment of 10%-30% of the loan’s value.

If you’re not required to put up collateral, which is rare, you’ll have to sign a personal guarantee, wherein you agree that the lender has the right to seize and sell your personal assets if you default.

Once you get a term loan, you’ll have to start paying it back right away. Usually repayments are made on a monthly basis with regular installments. With a construction loan, you only have to pay interest until construction is complete. In both cases, however, consistently making repayments on time will boost your credit, which is helpful if you want to refinance later to get a better interest rate.

SBA Loan

If you need financing to build or develop commercial property, consider getting a Small Business Administration (SBA) loan. Even individuals with bad credit and limited business history get approved for these loans.

There are several kinds of SBA loans, but most businesses get a 7(a) or 504 loan. To get either loan, your business has to make a profit, it has to be located in the US, and it must be unable to get financing from other sources.

When it comes to real estate, 504 loans are the preferred option. These loans usually have a term of 10-30 years with an average interest rate around 6%. There are also community-development requirements you’ll have to meet if you get a 504 loan to construct or develop commercial property. 7(a) loans can also be used for real estate development, but they have more use restrictions. If you already have an SBA loan, you can read out guide on the number of SBA loans you’re eligible for.

One thing to know about SBA loan interest rates is they’re capped, meaning they can only go so high. Also, it takes 2-3 months to secure funding, so they’re not ideal for businesses that need cash in a hurry.

You’ll need to put up collateral to secure an SBA loan greater than $50,000, and a down payment of 10%-30% will be required as well. If you default, you may be able to get a portion of what you owe forgiven if you’re accepted into their Offer in Compromise (OIC) program.

Lastly, it’s critically important that you don’t misuse the SBA’s funds. If you do, you’ll have to give back the money immediately and you may be severely penalized.

Final Thoughts

There are different kinds of construction loans, but most have an interest rate between 6% and 15%. However, the interest rate on any construction loan can be 15% or higher if your credit isn’t great and your finances are questionable.

To decide on a fair interest rate for your construction loan, your lender will consider your creditworthiness, the purpose of the loan, the term, the loan’s size, your down payment, building-specific factors, your income, and your debt-to-income ratio.