Financing the construction of your custom home can be one of those tasks that takes a little bit of heavy lifting. Construction financing seems to be a little bit of a mystery to most because it isn’t super common. For that reason, we wanted to break down the basics of what you should know about construction financing 101 so that when you’re ready to build your custom home in Saskatoon, you’re prepared and have a base knowledge at the very least!
To put it plain and simple, a construction mortgage is lending that you receive strictly for the construction of your custom home. A construction mortgage is an interest only loan – meaning none of your payments reduce the principle, they all go to Mr. Banker. As the construction of your home advances, you can oftentimes request disbursements anytime you would like although like any other mortgage, each lender has slightly different rules so make sure you ask about those up front.
As your build progresses and you request progress draws the balance of your mortgage will increase. Effectively when you begin construction the balance will be $0. As you request draws that balance will increase with each draw you receive. The interest that you pay each month is dependent on the total balance that you have withdrawn. This means that at the beginning of the build your payments could be just hundreds of dollars whereas towards the end they could be thousands.
Oftentimes the interest rates are pegged to the existing prime rate (it is common to see a rate at prime plus 2% for example). For this reason, construction mortgages are quite cheap in the beginning phases of your project and gradually get more expensive towards the end. Once your project has been completed you will then convert your construction mortgage into a term mortgage. A term mortgage is what anyone and everyone gets when they go to the bank to buy a home and is relatively straightforward.
Other than the fact that a construction mortgage is interest only, the other main difference from a term mortgage is the equity that you will be required to hold. Whereas you typically can have as little as 5% down in a term mortgage, construction mortgages are often in the ballpark of 20%. The equity positions work a little different however.
If you were to buy a house today with a 20% down payment you would be required to put that cash down up front. However, with a construction mortgage you’re not purchasing the entire property up front. You are essentially buying it as it gets built. Where this matters to you is that with each progress disbursement you will not actually receive the full value of the work completed. Instead, you will receive 80% of the work completed. The difference would be the 20% equity that the bank requires you to always hold. Effectively you are paying the 20% down payment overtime. That way by the time the home is finished the bank will have paid for 80% and you will have paid for 20%. Then once you convert the mortgage to a standard term mortgage there are no more monies owed for your down payment.
What are these progress disbursements that I keep talking about? Throughout your build you will receive invoices based on a payment schedule agreed ahead of time. If you are using financing instead of paying for the entire project with cash you will need progress disbursements from your construction mortgage to pay for these invoices.
Most lenders will require a progress appraisal from a professional home appraiser to determine how much of the home has been completed. Let’s say that the appraiser comes and determines that the house is 27% complete. In that scenario they would send a report back to the lender showing the same and the lender would disperse 27% of your construction mortgage to your lawyer. From there your lawyer would disperse funds directly into your account and you would have the funds to pay the builder’s invoice!
Builder’s Lien Act
If you are building a custom home in Saskatoon one thing to be aware of is the Builders Lien Act. This is law that states that every time a lawyer disburses funds to you they are required to hold back 10% of those funds. Effectively the purpose of this is to give sub trades the opportunity to report the builder if they are not getting paid. This 10% hold back occurs for 40 days after the completion of the project. You also will not have access to this money until after those 40 days. This is something to keep in mind and be aware of to make sure that you can make payment in full and receive possession on time!
If you are interested in hearing more about construction financing before you start your custom home building journey, follow the link below to listen to our podcast where we interviewed a local mortgage broker to help give some more thought and insights!