We Walk You Through the Financing Process for a Home Construction Project
Construction financing is booming in Ontario as more and more homeowners consider custom home builds to meet their needs.
As exciting as building a home designed around your needs and preferences is, it’s not without its challenges. Buying land for construction is a more involved process than qualifying for a mortgage, after all, and often requires a bigger down payment.
You’re still getting a mortgage, but with a different structure and approach than standard home ownership. Even then, you’ve still got options.
Let’s take a closer look:
Types of Lender
There are three primary types of construction financing:
- Large financial institutions, such as big banks.
- Smaller financial institutions, such as credit unions.
- Specialized construction lenders.
In short, the large institutions offer lower rates and much less flexible products, while credit unions are usually costlier but a bit more flexible.
Meanwhile, specialized construction lenders offer higher interest rates but significantly more flexible products.
Loan to Value (Percentage of The Value of the Home Being Financed)
Most financial institutions require you to purchase the lot with your own funds, and then they finance 75% of the construction cost. This is often not realistic for self-built home builders as it requires a lot of cash on hand.
Credit unions will often finance the lesser of 50% of the lot value or the lot purchase price, then they will finance the lesser of 80% of the construction cost or 80% of the future value.
Specialized construction lenders normally finance 50 to 65% of the lot value and then 80% of the future value. In this scenario, you normally don’t require any more cash on hand after the down payment for the lot.
Interest Rates, Fees and Payment Structures
Interest rates can vary significantly.
With big banks, they can be as low as the current best rates and terms (for example, 2.6%). In some cases, you start making monthly principal and interest payments on the entire future funded amount.
This can make the monthly cash flow tight during construction. There are usually very few fees involved, but they may cost up to 1% of the mortgage amount.
Credit unions often have monthly interest-only payments during construction, and there is often a fee that comes to approximately 0.85% of the future funding amount. They sometimes offer unlimited draws. Interest rates are usually between 3 and 4%.
With specialized construction lenders, you typically make interest-only payments deducted from the next financing draw. This means you don’t have to pull money out of your pocket. There is usually a 2% fee on the entire funded amount, paid up front, and a rate of 6.99 to 14%. In most cases, borrowers pay 12% interest-only payments deducted from the next mortgage draw.
All lenders allow you to do construction draws. This means they lend you money as needed based on the percentage of the project being completed.
For example, once the foundation is completed, this might mean the project is 20% complete. Your lender offers up to 20% of the final mortgage amount (including the lot financing already financed, if any).
Banks usually have a limit of 3 or 4 mortgage draws.
Credit unions sometimes offer unlimited draws and require 10% holdbacks on the funds disbursed.
Specialized construction lenders usually allow you to do as many financing draws as needed.
In all scenarios, there is a 10% hold back on the funds being disbursed. This is in agreement with the construction lien act to ensure pay the contractors. You usually gain access to these funds 45 days after you have received your occupancy permit.
What Happens Once Construction Is Complete?
Once construction ends, we usually refinance the home in a more typical mortgage contract. With the big bank or credit union, your mortgage often converts to a more normal mortgage product and rate once the construction is complete.
If we finance the construction project with a specialized construction lender, then once the construction is completed, we refinance your construction mortgage to a mortgage lender like a big bank, mortgage company, or credit union at best rates and terms.
My team and I have access to all three of these leading lenders. Most clients choose a mortgage with specialized construction lenders because construction financing with a bank is often too restrictive and requires too much cash on hand.
The credit unions offer a more flexible option on paper, but the turnaround time can be very slow. Some clients also want to avoid the credit union because borrowers must become a member, which often requires a monthly or annual fee.
More importantly, the credit unions are much pickier with their financing. They usually require that the borrower live or work within a certain distance of a branch.
It’s important to note that these are simply general details, and that there’s no hard and fast rule for picking a lender. Once you are close to having a real project on your hands, then we will determine which option is best for you.
I often tell my clients, for budgeting or number crunching purposes, to do the math in the costliest scenario. If you’re satisfied with those figures, then it can only get better from there.