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How Does Construction Financing and Building a Home Work?

Construction financing isn't as simple as getting one big lump sum from the bank to build your home. There is a good deal of criteria to be met, including appraisals and different stages of development being signed off on. We are here to help you navigate construction loans and can help you with your next project.

“Building is about getting around the obstacles that are presented to you.” – Jeremy Renner

It was Thursday at 3 pm when John called me. He had just purchased his dream lot after five years of saving. Now he was ready to build his dream home and he wanted to get a construction loan… there was just one problem… we had never spoken before and he used all of his savings for the down payment on the lot. I took a deep breath… this was going to be a hard call. John was stuck, he did not know how construction financing worked and he was about to get a crash course.

One of the most common questions I get from buyers and owners alike is about renovations and construction. Construction financing covers everything from turning a dirt lot into a dream home, renovating your kitchen with a purchase plus improvements mortgage and building investment properties.

A Progress Draw What?

The biggest myth about construction loans is that the bank gives you the money to build the home. I imagine this was the case many years ago but at some point, someone took the cheque to Vegas and things changed.

Currently, most construction loans use a draw system. A draw is essentially a cash advance given at certain construction milestones.

Most lenders offer five draws. Typically a land draw (50-75% of the land value), an advance at the lockup stage ~40% (doors and windows are installed and you can physically lock the property), at 65% completion, and two final draws usually around 80% and 95% completion.

It is important to know that the completion of the build is based on a site visit, often by a real estate appraiser. Certain lenders will advance funds based on the % complete whereas other lenders will require exact milestones met. It is important that anyone building understand exactly how and when their lender will release funds. These visits are generally covered in the lending fees but you should always confirm

What Does a Construction Loan Cost?

Most construction loans have interest-only loans with floating rates based on the bank’s prime (P). Often these range from P+0.5% to P+1% but a few lenders are as low as P-0.4% for construction.

Often these types of products have fees ranging from $1000 to $5000 in addition to the interest costs.

Take Out Mortgage

At the end of your construction financing, the lender will convert you from your construction loan to a permanent loan. It is important to know that most construction loans are not open (penalty free) and if you sell the property or go to another lender the penalties can be massive (even bigger than fixed rate products). Some lenders will guarantee a rate for your final mortgage before construction starts while others will guarantee a discount. This can be the difference of getting a rate of 3% or 5.5% so it is key that you confirm this before beginning your project!

How is the Value of My Home Decided if I Have not Built it Yet?

Once you have decided on a piece of land and a construction contract in place an appraisal will be ordered. Similar properties that have sold in the last 3-6 months will be used to set a value for your build based on the construction plans. Due to this you must be very careful with significant changes to the building during construction.

Two Types of Construction Contracts

Fixed price contracts put the burden of rising costs on the builder and lower the risk for the owner. It is important that you choose a reputable and established builder as some may simply walk away from your build if costs rise or the project faces challenges.

Generally, lenders frown on cost plus construction contracts but many owners prefer these as they can have a lower cost. The reason for this is that the owner takes on the risk of rising costs. Some lenders will not allow cost plus contracts but a few have work arounds that require specific wording on the contract.

How Does Building the Home Myself Affect the Loan?

Building a home yourself is often referred to as a self-build. Some lenders prohibit this while others require the owner to inject more cash into the build by restricting loan to value (how much money they will give you relative to the value of the build).

There are some work arounds and tricks that you can use for self builds but as a general rule of thumb know that it is more difficult and restrictive to build yourself (compared to using a third party general contractor).

Building for Profit

Most residential lenders will not allow properties built strictly for resale purposes. The lenders that do consider this are generally commercial lenders and come at a higher cost as well as stricter rules.

Building property to keep as a rental is a little more flexible. Some lenders will allow it (while others only allow for primary residences and second homes) but it is important to know most lenders will not use rental income from the property (there are exceptions to this though if you need rental income to qualify).

Construction inside of a corporation is very difficult residentially but can be done with commercial lenders.

An Example of a Construction Loan 

Sarah wants to build her dream home and is purchasing a $500,000 lot and her contractor has provided a fixed price construction contract for $450,000.

When Sarah purchases the land the lender will provide a mortgage for $375,000 (75% of the land cost).

During construction, the lender will advance her funds at the following stages of completion – 20%,40%,60%,80% and 100%.

This means that Sarah needs at least $215,000 to build her new home. In addition lenders typically want to see at least 10% of the construction costs in reserve so she would need to have an addition $45,000 in liquid assets as a safety net.

At the end of the build Sarah will have $190,000 left in the deal and a mortgage of $760,000.

Curious about construction loans or have questions about your mortgage? Please don’t hesitate to reach out. Be proactive and don’t get into a detrimental situation that could have been avoided. 

Find out more

As mortgage broker’s we are on your team. Our job is to understand your needs, plans and wants in order to understand your mortgage needs. We then look at a number of lenders to find the best products and solutions for you.

During our time in the industry we have learned a number of tips and tricks to help you save money and to pay of your mortgage faster.

If you have any questions or would like a customized mortgage plan let us know!

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