Buying a home is an exercise in planning, patience, perseverance, and about a hundred
other virtues that don’t begin with a ‘p’. Building a custom home is all of these without even
first getting to see what you (and your lender) are paying for. Which can be a little stressful…
OR may just turn out to be the ultimate self-improvement journey. In a zen kinda way.
Construction loans provide finance for, yes, the construction of homes. The essence of a
construction loan and a mortgage might be the same: a lender provides money at specified
terms for the acquisition of a home, but that’s where the similarities end. And it’s really
important to understand what you are getting yourself into.
What even is a construction loan?
Well, one clear-as-day difference is that with a construction loan, you don’t get all the money upfront. The loan is divided into 4 or 5 portions, and these are paid out (or disbursed) to the builder (through your lawyer) in “draws”, according to the progress on the project.
The amounts of these draws can either be calculated on a percentage basis, or broken up according to the budget in chunks that correlate with certain milestones, like laying the foundations, putting on the roof, finishing the plumbing and HVAC,etc. A draw could also include the purchasing of the land if you are doing a custom build.
Your builder will request funds from you to complete each specific phase of the project. Before paying out a draw, your lender will send an appraiser to inspect the site and report back on the progress and amount of work completed. The results of the inspection will be used to calculate the size of the next draw. These inspections come with a fee, of course, which are for your account. Of course.
A 10% portion of each draw will be held back by the lender in accordance with the Builders Lien Act, which helps to protect tradesmen and contractors and ensure they get paid for work done. If no claims have been made against your property, this money will be paid out to you 55 days after completion of the construction.
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Is it in your interest?
Lending money for the construction of new homes is risky(er) business. That’s because the home is not yet built so the collateral for the bank is an “unfinished” home with a lesser value than the total loan amount.
Lenders offset this risk by offering loans at higher mortgage rates, with more stringent eligibility requirements. They will not only consider your credit score, income, and debt, but will also require a full budget and cost analysis of the build, construction plans and blueprints, and information on the builder to ensure you are employing a credible contractor with a history of good and completed works.
With each draw disbursed the amount of interest you pay increases (because it gets charged according to the outstanding loan amount). You have to make monthly payments on your construction home, even if construction is ongoing and your home is not occupied. There are some lenders who only require monthly payments of the interest owing - you only make principal payments once construction is complete.
The short and long of it.
Where a mortgage is usually set at a 25- to 30-year term, a construction loan is short-term, and is generally limited to 1 year. When the term is over and the construction is complete, you are required to either pay back the loan in full or refinance it into a traditional mortgage and pay it off over a long term, as you would if buying an existing house.
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Will they pick up what you put down?
Most often, lenders will only allow you to borrow 75% of the total amount you require. This means that you need to pay a (considerable) 25% down-payment out of your pocket to the lender to secure the loan. If you are purchasing a production home, you will also need to pay a deposit to the developer, which can be paid over a period of time, with 5% put down immediately to secure the contract. If you are buying land, you will need to pay a deposit to secure the transaction. Basically, there’s a lot of paying in advance of your own hard-earned moolah in order to get this dream off the ground.
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Embarking on a custom build is truly the adventure of a lifetime. Which at times will be incredibly harrowing. A good lender and good construction loan can not only make it possible, but will also reduce the financial stress of the endeavour. And if all goes well and according to plan, you might even find a little extra left over. You know, just in case you decide to get that dappled forest wallpaper for your zen den after all.
