Everything You Need to Know About Getting Financing as a Contractor
June 10, 2022
Construction is a growing industry in the United States, and getting a loan as a contractor can help your company take advantage of the industry’s long-term growth. According to Statista, construction on new homes is up almost 4% year-over-year compared to 2021, and private sector customers spent a reported $1.6 trillion on new construction projects in 2021. In fact, home construction spending has been growing year over year since as early as 2011.
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With homebuyers looking to renovate and new homeowners looking to build, the contracting industry is lucrative. So if you want to break into or improve your position in the contracting industry, you’re going to need small business loans. It’s an expensive industry, and seeking external financing is key to getting ahead.
Why You Need Loans as a Contractor
Forms of Contracting Business Loans
Lines of Credit
Why You Need Loans as a Contractor
The most important investment in your contracting company will be the equipment. Every construction project is likely to require a fairly large amount of specialized expensive equipment to complete. Your company’s specialization and the type of construction you’re looking to do will also inform the loan amounts and type of equipment you’re going to need.
You’re going to need an extensive array of high-quality power tools. You’re going to need the ability to transport that array of tools not only to the worksite (requiring a truck or trucks), but you’re going to need to be able to bring the tools at the worksite to the exact areas they’re needed.
Are you planning to be a general contractor? If so, you may be able to limit your more specialized equipment, as you can sub-contract specialized tasks to more specialized companies. But if you’re planning to take on some of that work yourself, specialized equipment is extremely expensive as well.
Getting the word out about your contracting company is key to its overall success. Any homeowner looking for a construction business will be looking in any number of spaces and sources for the right builder. For that reason, marketing can be incredibly expensive. Some construction companies simply outsource the marketing side of the business by hiring an external firm. Even if that’s not the avenue you prefer, setting up online campaigns, social media marketing, print advertisements, and more can add up in cost very quickly.
You’re going to need cash flow throughout the duration of your company’s life, and contracting (particularly if you’re a home builder or other seasonally-based specialist) can be an unforgivingly seasonal industry. Seeking external financing can help make sure that during lean times, you’re able to keep equipment in top shape, pay employees, and otherwise ensure that once it’s time get back into the swing of peak business, you’re able to do so.
Forms of contracting Business Loans
Because of the many different expenses involved in running a contracting company, contractor loans can take any number of shapes. Ideal financing for a fleet of vehicles isn’t the same as the financing you need to purchase an office. Depending on your exact needs, the type of loan best suited to your company can take any number of shapes.
The most basic loan option in the market is a basic traditional loan. For traditional loans, a lender examines the creditworthiness of a potential borrower by examining their credit history, bank statements, credit report, debt-to-income ratio, and more. Once the lender has finished that examination they can choose to dole out a loan as a lump sum of cash. The borrower then makes monthly payments on that loan along with interest. The interest rate and size of payments depend on a few factors, including the size of the loan, the loan term, and the borrower’s credit. Also known as term loans, one of the biggest upsides of a traditional loan is their malleability. A term loan can be used to pay your employees, purchase or lease a vehicle, stock up on necessary supplies, or function as working capital.
As with any loan, it’s important to remember that for a lender, underwriting a loan is effectively the same as placing a bet on whether or not the borrower will be able to repay that loan at the agreed-upon interest rate. The simplest way to evaluate your ability to repay a loan is by looking at your credit score, so when you’re looking for a loan, you’ll want to do everything possible to make your company appear like a safe bet that will be able to repay the loan without undue financial stress. The more dependable the borrower, the more favorable the terms from the lender. Making yourself a safe bet means regular credit checks showing you’ve got good credit, excellent bookkeeping and accounting, correct and complete tax returns, and a sensible business plan. If you’ve got bad credit, lenders might choose to saddle you with higher interest rates, smaller loans, and shorter terms in order to protect the lender from the risk of losing money.
SBA Loans (Particularly Microloans)
The United States Small Business Administration (SBA) uses taxpayer dollars to guarantee a certain number of loans each year. That taxpayer guarantee functions as something of a safety net for lenders. Whereas traditional term loans we discussed above put these lenders in a position where they can lose money if a small business owner defaults on the loan, SBA loans are guaranteed by the government. If the borrower can’t pay back the loan, the lender receives a large percentage of the default amount from the SBA.
The SBA is very careful about which businesses receive guaranteed loans because they’re being guaranteed by taxpayers. That stringent standard means SBA loans are complicated to apply for and the loan application process can take considerably longer than other types of loans. However, the combination of high standards for borrowers and a guarantee from the government means that lenders are able to offer qualifying borrowers very favorable terms for these loans.
There are two main forms of SBA loans to be aware of. SBA 7(a) loans can be for up to $5 million and have a repayment term of 10 years or 25 years, depending on the purpose of the loan (most likely 10 years for contracting companies, as 25 years is reserved for larger real estate purchases). 7(a) loans are also variable rate loans. Your interest rate is based on both your credit history and the current US prime interest rate (the rate at which the U.S. Federal Reserve lends to their most creditworthy borrowers – large banks).
SBA 504 loans are fixed-rate loans of up to $5 million that must be used to finance assets intended to grow a business or create jobs. While 7(a) loans can be used in many different ways, 504 loans must be used for very specific projects – projects like contracting, building new facilities, or modernizing roads. They’ve also typically got longer repayment terms.
Most helpfully in the contracting business, the SBA also offers a microloan program. These are loans you’ll receive through local nonprofit groups. SBA microloans can be up to $50,000 and, like 7(a) loans, can be used for a variety of purchases. There’s certainly much to purchase when you’re first starting in the contracting industry, but the expenses won’t be as high as they are for starting up a restaurant, for example. For that reason, microloans can be a great option.
Business Credit Cards
Business credit cards function exactly like personal credit cards. Depending on your creditworthiness as determined by the credit card company, you’ll receive a card with an agreed-upon spending limit and interest rate. As you make purchases with that card, you’ll make monthly payments based on what you’ve spent below that credit limit.
Business credit cards are particularly helpful due to rewards programs. If your company does construction in a wide radius, it can be expensive to transport multiple trucks every day. But if your business credit card gets you 3% cash back on gas, you can not only give yourself a tidy discount on a necessary supply but also build credit for your company.
Equipment loans are meant specifically to help finance business equipment. As discussed earlier, the contracting industry is strongly built around equipment, which makes equipment financing a powerful way to get the supplies you need to get jobs done.
Unlike traditional loans or credit cards, equipment financing must involve a specific, agreed-upon equipment purchase. For a contracting company, that could be a bulldozer, which often cost around $100,000. The borrower would make a down payment on the dozer, and then use equipment financing to pay for the rest. The lender would then hold that new equipment as collateral. That means that if the borrower is unable to repay the financed portion of the purchase price, the lender is able to repossess and sell the equipment to recoup its lost money. This is known as a secured loan – the borrower has offered something valuable as collateral (alternatively, an unsecured loan is when no collateral exists). That protection against losing considerable money means that equipment financing often includes favorable terms.
Lines of Credit
Lines of credit are great options to have in case of a short-term emergency. In a business line of credit, a lender evaluates the creditworthiness of a potential borrower and then approves them for a particular credit limit from a bank, credit union, or other financial institution. Once that limit and interest rate are agreed upon, business lines of credit function much like a credit card. You’ll only make payments and pay interest on money spent under the limit.
Lines of credit are particularly helpful when unexpected expenses pop up. If you’re building a home and the equipment needed to raise ceiling joists breaks down, you can’t build a house anymore. That means critical delays and loss of revenue. But if you’ve got an excellent line of credit, you can easily and quickly finance an emergency purchase, which will help keep the job moving and cash flowing.
Alternative Financing: Merchant Cash Advances
Finally, there are merchant cash advances. It’s important to distinguish that cash advances are, by definition, not loans. Instead, the lending party is purchasing a percentage of future debit or credit card sales. The borrowing party then repays the advance using a factor rate multiplier, typically a number between 1 and 2, depending on creditworthiness and the size of the advance.
If you receive a cash advance of $10,000 at a factor rate of 1.3, it means you’re agreeing to repay the original amount (10,000) multiplied by the factor rate (1.3). You’ll repay $13,000. Payments are typically made on a daily basis depending on the number and rate of credit card transactions.
Cash advances are hugely beneficial for many small business owners because the payments vary in size depending on cash flow. If you’re processing many credit and debit card transactions, you’re going to be making more and larger payments. Because of the seasonal nature of the contracting business, there will inevitably be slow times and fast times. A cash advance during the slow times will require smaller payments, while a traditional bank loan might keep payments the same size, handicapping working capital.
Contracting Company Financing Can Be Complicated
With so many financing options available for every contracting company, it can feel like learning an entirely new language when you’re looking to acquire a bit of extra cash for your business. So be sure to take it step by step.
Understand why you need a loan. What are you looking to buy? Who are you looking to pay? Then, put your company in an optimal position to receive the best possible terms. Refinance existing loans, pay off long-term debt, or reduce balances on lines of credit to ensure maximum creditworthiness. And finally, use your loans wisely to create a profitable future for your contracting business.