What is construction financing?
By Alisa Aragon-Lloyd, as seen in "Home + Reno Guide" magazine, April/May 2023
If you’ve owned your home for many years, you probably have a considerable amount of equity that you can use to renovate or build a new home. If you haven’t considered construction financing, read on to find out if it is a good option for your project goals.
Before you begin
The first step is to surround yourself with a great team to help and guide you throughout the entire process. This would include a mortgage expert experienced in construction, plus a reputable and licensed builder/contractor or certified renovation professional. The builder/contractor should be licensed under B.C. Housing and a member of a recognized new-home warranty program.
Construction financing supplies funds for you to build a new house, undertake a major renovation or tear-down what you have to build a new home on the property that you already own or a property you are looking to purchase.
This is a short-term loan to take care of expenses related to the construction process such as materials, labour and permits, and can be obtained from a variety of sources, including a bank, credit union, a mono-lender (lenders that only work with a mortgage expert) and private lenders.
Once the renovation or the home is completed and the final occupancy permit is issued, you will typically refinance or convert the construction loan to a long-term mortgage or sell the property to pay off the loan.
How it works
A construction loan requires a down payment for the purchase of a different property or equity taken if you own the property. This type of financing usually has higher interest rates and fees, and is more capital intensive than a traditional mortgage, as there is greater risk involved in lending money for a construction project.
You need to ensure you have enough capital to complete the project to get to the next stage, since a lender will not advance funds until each stage of the work has been completed. Also, the loan is based on a “cost to complete” and not the future value of the project — most lenders go up to 75 to 80 per cent loan to complete.
You’re going to want to draw up an accurate budget that should include the land value, soft costs and all hard costs. The land value is the lower of the purchase price or the appraised value of the land.
Soft costs are fees indirectly related to the project such as architectural consultations/designs, interior design, engineering and permits, to name a few.
Hard costs are related to the hands-on construction such as labour and raw materials. Both soft and hard costs are essential to the project.
You should also have a contingency fund of at least 10 per cent to cover cost overruns, such as an increase in the price of materials or labour. Make sure you have a clear understanding of the lender’s funding requirements as well as the builder/contractor and renovator’s payment schedules during every stage of construction.
The lender will release funds based on draws while the builder/ contractor and renovator will require payments based on the stages once the foundation, framing and interior are completed.
An exciting time
Whether you are venturing into a major renovation or building a brand-new home, it is an exciting time, and construction financing can help you get there. However, the process can be complex, with a lot of moving parts. Choose a good team, including a mortgage broker who understands the ins and outs of construction financing to find the best lender for your specific needs and situation.
Construction financing typically works in several stages
Application: When you apply for a construction loan from a lender, you must provide details about the project, your financial history and any other relevant information, as well as a signed contract from a builder/contractor or renovator, including a budget for the entire cost of the construction project along with floorplans and front and side elevations of the house.
Approval: The lender reviews the application and decides whether to approve the loan, taking into consideration your credit score, income and the feasibility of the construction project. They will also require an appraisal to confirm the value of the property once the major renovation or new home is completed based on the budget, drawings and current market conditions.
Loan terms: If approved, you will receive the loan terms, including the loan amount, interest rate and repayment schedule.
Disbursement: The loan is usually disbursed in installments, known as “draws” as construction progresses. The lender usually sends an inspector to the construction site to verify that the work has been completed before releasing the next draw of funds.
Once construction is complete, you can refinance the loan with a long-term mortgage or sell the property to pay off the loan.