Construction loan financing
For individuals looking to enjoy the comforts of a customized home, building a brand new one is the most suitable option. However, constructing a house is just as costly as buying an existing one. As a result, seeking financial options is a must. One of the most popular financial solutions for building a new house is a home construction loan. This financial option allows individuals to borrow money to pay for materials and labor throughout the course of their construction project. With sufficient financial backing, they don’t have to compromise on quality, design, or even plot selection.
How are construction loans different from mortgages?
Mortgages are generally meant for the purchase of existing properties. They have longer terms and lower interest rates. On the other hand, construction mortgages are short-term financial instruments that are paid out in parts. That means payment is made towards the project at different stages, as discussed with the lender.
How do construction loans work?
Construction loans can also be called draw mortgages as they offer finance to pay contractors and for supplies. The funds associated with the loan may be disbursed by the borrower’s lawyer or directly by the lender to the contractor.
The draws are paid at different stages during the construction process, so the contractor doesn’t receive the entire amount in one go. The contractor is only given an amount that is proportionate to the work that needs to be completed within a specific period of time. This setup ensures that the loan money is used carefully for the intended purpose.
With construction loans, lenders will cover up to 75% of the construction cost. The borrower must maintain a 25% equity investment via their own funds or through their built up equity. For this reason, borrowers must plan ahead, so they have sufficient savings to cover their portion of the building expenses.
Construction loans will offer a few options. For example, if the borrower isn’t using a general contractor or home builder, they can obtain a self-build construction loan. This option offers financing to build the house themselves, provided they have the required experience for the job.
Understanding construction draw schedules
Construction draw schedules are meant to outline when construction draws have to be paid. A draw schedule must be negotiated before the actual construction begins. Banks usually have standardized draw schedules, but the borrower’s contractor or the bank appraiser can offer other payment schedules to meet unique circumstances.
For example, changes may be made to the draw schedule when the construction timeline or costs differ from what the lender expected. Construction draw schedules can be based on milestones too. Some milestones can be the laying of the foundation and installing the roof. Otherwise, the draw schedule can be prepared based on the general percentage of the total work completed.
How many construction draws can be received?
Most lenders, like banks, offer four draws, sometimes five. Other lenders may be more flexible and allow additional draws. The lender will send an appraiser to see the progress of the construction before additional funds are released to complete the next stage. An inspection fee may be charged each time, depending on the lender.
Repayment of the construction loan
When it comes to repayment of a construction loan, borrowers must make monthly payments. That is, even if the construction is still in progress or the house is not occupied. Many lenders will require monthly interest-only payments during construction. For other lenders, this may be different. But once the construction is completed, principal and interest payments will be compulsory. Some construction lenders may even allow the use of future construction draws to pay for interest on the loan.
Construction loan interest
The interest on construction loans is incurred after each construction draw is disbursed. To reduce interest costs, borrowers may try to postpone draws as much as possible during the construction. But contractors may want their money as soon as possible. In such a situation, lenders or the contractor may suggest an alternative payment schedule. Borrowers must review this new proposal to determine if it is a reasonable solution for them and their contractor.
Applying for a home construction loan
Construction loans can be availed of by anyone interested in building a house, provided they have the ability to pay a specified percentage of the construction cost. This is similar to a down payment made when availing of a mortgage. Construction loans also require collateral, but unlike with a mortgage, here the collateral is the unfinished house. As the collateral value is low with construction loans, the interest rate of a construction loan can be high.
To see if a borrower is suitable for a construction loan and eventually a mortgage (as the construction loan can be converted into a mortgage upon the completion of the construction), lenders look into their income, debt levels, and credit score. If they match the lender’s requirements, they will be granted the loan. But, the eligibility criteria are much stricter for construction loans than regular mortgages.
Can construction loans be used to buy land for the construction?
Yes, they can be used to buy the land on which the new house will be built. The money used to buy the land will be considered the first draw. This amount can be paid out in advance. That is before the construction starts. The first draw amount can vary between 65% to 75% of the cost of the land. Unfortunately, not all lenders pay the first draw in advance, so borrowers need to ensure they are smart with the lenders they choose. Otherwise, they may have to shoulder the land purchase expenses on their own.
What happens when the construction is finished?
After the house is built and ready to move into, the construction loan can either be paid in full or refinanced into a conventional mortgage product. Here, the details must be verified in advance to avoid any issues once the construction is completed. Borrowers can speak with a mortgage broker to help them figure out this step and ensure the costs of refinancing are affordable and transfer hassles are eliminated.
Do contractors receive the entire amount of the construction advances?
According to a province’s Builders’ Lien Act, there is a construction holdback whereby 10% of the payments due are withheld for a specified period. The British Columbia’s Builders Lien Act and Alberta’s Builders’ Lien Act have such requirements. These laws differ from province to province. Either way, once the construction work is completed, the remaining percentage of the payment due will be paid to the contractor after a holding period of at least forty-five days.
During these forty-five days, the contractor can file any lien claims against the property. Borrowers may be asked to sign a Certificate of Substantial Completion, which is done once 97% of the home construction is complete. Borrowers need not sign this certificate if they are not satisfied with the contractor’s work.
Two construction loan financing programs you can take advantage of
A. Home improvement mortgages
One can seek more finances on their mortgage for home improvements or renovations with an improvement mortgage. Some lenders may offer an additional amount on top of the home purchase price. That way, buyers can cover minor improvements as necessary.
The Meridian’s Purchase Plus Improvement Mortgage allows individuals to borrow up to 20% of the purchase price of the home, which is up to a maximum of $40,000. They can then use this mortgage to purchase the home they want. The additional improvement funds will be released only once the borrower has completed the intended improvements.
With home improvement mortgages, a down payment is a must. But as home improvements increase the value of a house, the down payment required will also increase. The down payment needed will be calculated based on the property’s new value or the purchase price of the property plus the costs for improvement. It depends on whichever is the lowest.
B. CMHC rental construction financing
Those interested in developing multi-unit rental housing can qualify for funding from the Canada Mortgage and Housing Corporation (CMHC). This financing program offers up to 100% of construction costs or 85% of the property’s lending value, depending on which is less, with a minimum of $1,000,000.
Additionally, the mortgage loan insurance for CMHC rental construction financing is available for free. No CMHC premiums are required. CMHC financing is available for a ten-year term with a fixed interest rate for up to a fifty-year amortization period. During construction, only interest payments are required.
To apply, one will be charged an application fee by the CMHC. The application fee is $200 per residential unit, or 0.3% of the loan amount over $100,000 if non-residential.
For more insights on construction loans and the available programs under this form of lending, reach out to Boychuk Mortgage Group. Our founder is a dedicated and accredited mortgage broker in Burnaby, British Columbia. Under his guidance, we take great pleasure in providing clients with suitable mortgages that support their needs for today and the goals of tomorrow. We also secure for them a safety net given any changes that may come along in life. This ensures our clients a worry-free experience throughout the course of their mortgage.