Construction loan: definition
A construction loan is bank financing used to cover the costs of building, converting or carrying out major renovations to a property. Unlike a standard mortgage, the full amount is generally not paid out at once: funds are drawn progressively as the work advances and invoices become due.
How does a construction loan work?
The bank generally opens a construction account through which the project costs are managed. Invoices from architects, contractors, tradespeople and suppliers are then paid from this account.
The loan is therefore drawn progressively. At the beginning of the project, only a small part of the approved amount may have been used. As the work progresses, the amount drawn increases until the financing required for the project has been reached.
Interest is generally calculated on the amount actually drawn, rather than on the entire approved credit limit. The precise terms nevertheless vary between lenders.
What can a construction loan be used for?
A construction loan can be used in particular to finance:
- the construction of a house or residential building;
- major alterations to an existing building;
- an extension or additional storey;
- a complete renovation involving numerous successive payments;
- architects’ fees and the fees of other professionals involved in the project;
- certain ancillary costs accepted by the bank as part of the construction budget.
For smaller projects, a construction loan is not always necessary. Increasing the existing mortgage or using another form of renovation loan may be simpler.
From construction loan to mortgage
A construction loan is normally a temporary financing solution. Once the project has been completed and the final cost is known, the financing is generally consolidated into a mortgage.
The amount drawn under the construction loan is then replaced by one or more mortgage tranches, for example a fixed-rate mortgage or a SARON mortgage.
This conversion may take place all at once when the work is completed or progressively, depending on the structure agreed with the bank.
What does the bank assess?
Before granting a construction loan, the bank will typically assess:
- the price of the land or the value of the existing property;
- the detailed construction or conversion budget;
- the available plans and permits;
- the borrower’s equity;
- the estimated value of the property once the work has been completed;
- the affordability of the final mortgage financing.
The bank may also request quotations, a construction schedule, contracts with contractors or additional supporting documents before releasing certain payments.
A simple example
Suppose a construction project requires CHF 800’000 of bank financing. The bank grants a construction loan limit corresponding to the amount approved in its financing plan.
After the first stage of the work, CHF 150’000 has been drawn. Interest is therefore calculated mainly on this amount actually used. A few months later, cumulative payments reach CHF 500’000, so the interest cost increases accordingly.
At the end of the project, if CHF 780’000 has ultimately been drawn, this amount can be converted into mortgage financing, subject to the final valuation of the property and the terms agreed with the lender.
Construction loan or construction mortgage?
In everyday usage, the terms construction loan and construction mortgage are sometimes used in similar ways. However, they do not describe exactly the same stage of the financing process.
The construction loan mainly covers the period during which the work is under way and funds are drawn progressively. The mortgage then provides the long-term financing for the property once construction or conversion has been completed.
For a detailed explanation of the different financing stages, the equity required, interest during the construction period and final consolidation, see our complete guide to construction mortgages in Switzerland.
In summary
A construction loan makes it possible to finance the costs of a property construction project progressively. Funds are generally drawn as invoices become due, and the loan is then converted into a mortgage once the work has been completed.
It is therefore primarily a form of temporary financing between the start of the construction work and the establishment of the final mortgage financing.
