What is a Construction Loan?
A construction loan or mortgage is a specific type of financing that can be used for a few different reasons, such as:
- building a home on land you already own
- purchasing a home where the builder gets paid in installments
- building on newly purchased land
- home renovations on a newly purchased home
Construction loans are short-term loans with higher interest rates than traditional loans or mortgages. Typically, with most construction loans, mortgage interest-only payments are required during the construction phase. Once it is complete, the loan or mortgage is then refinanced into a traditional loan or mortgage.
While a construction loan usually covers most builds, there may be some lenders that don’t finance things like apartments or condos. They also usually only cover the basics of the build and not things like appliances and home furnishings. A different kind of loan is often needed for those things.
Construction loans are designed to keep payments low during the construction phase. This allows the owner to put more money into the build and worry about the larger payments later, once the loan is refinanced.
How Construction Financing Works
Getting a construction mortgage, also known as a builder’s mortgage, can be much more difficult than getting a regular mortgage. When it comes to getting financed, the lender doesn’t give you the money up front to fund the build. When a lender agrees to give you the money to fund a build, it is disbursed in 4 to 5 installments. These amounts are set by the lender when the paperwork is being drawn up and are not determined by how much money is spent on the build at each stage.
Because the funds are released in stages, you, as the owner, need to ensure that you have a good schedule and a way to pay the construction costs or some kind of arrangement in place to pay later on. This ensures that the build is not halted at any point due to a lack of funds.
The set times for receiving funds from a construction mortgage lender aren’t based on fixed time periods but on different stages of the build’s completion. The lender sets these milestones, and they usually send someone out to verify that the milestone is met before the next portion of the funds is received. Once all milestones have been met and the home has passed its final inspection, the construction mortgage can be paid off in full or refinanced into a permanent mortgage.
Down Payment Required for Construction Financing
How much of a down payment is required for a construction mortgage eligibility really depends on the land. If you are purchasing the land at the same time as starting the build, a down payment of around 25%-35% is usually required. If you own the land outright, then the circumstances are a little bit different.
Owning the property outright before starting a build allows you to access the land’s equity or use it as collateral. This can save a lot of money on your construction mortgage and, in some cases, you may not even need to get a construction mortgage depending on the amount of equity that you have. This is also the case if you have owned the land for a while and have already paid a good portion of it.
Where to Get a Construction Loan
Getting a construction loan, just like any other type of financing, can be done through a mortgage loan officer at a traditional lender or through some private lenders. That said, construction loans are a bit trickier to obtain because they pose greater risks to lenders. With a traditional mortgage loan, lenders have collateral to use if the borrower defaults on the loan. With a construction mortgage, the bank has more to lose. This is why construction mortgages are paid in portions, also known as a draw schedule.
Since it is a bit more difficult to get a construction mortgage, a good option may be to work with a mortgage broker. They can help you find the right lender to finance your new build and determine whether a private or traditional lender is better for your situation.
Applying for Construction Financing
Now that you are ready to start the construction mortgage process, it’s time to get your documents together. You will need to show that you have a down payment or some kind of collateral, proof of income/employment, any current assets you already own, and any current debts that you have. They may request other information or documents depending on your situation.
Once you have provided that information, you need to start providing information regarding the build.
- Information regarding the builder. They usually like references and a list of previous construction projects. They want to ensure the build is licensed and reputable. This puts less overall risk to the lender.
- A detailed plan. This includes the floor plan, projected budget, estimated timeline and a list of all supplies, contractors and subcontractors involved in the project.
- An appraisal. Lenders like to have an appraisal done. This means that not only will they appraise the land the home will be built on, but they will also appraise the projected value of the home.
- Down payment. Down payments tend to be a bit high with construction financing. They usually require 20-25% down to help reduce their risk on the project.
Financing for Builders
Builders often have to go through similar channels to get their projects funded. The first few are the hardest, but once they can show some history, it becomes easier to get more loans. Most builders have relationships with various lenders and investors. Building and land development can be very expensive, so more than one lender or investor is often needed.
What are the Construction Loan Rates in Canada?
Right now in Canada, the construction loan rates typically range from prime + 0.5% to prime + 1.0%. That said, this rate will vary depending on the lender and whether it’s a conventional or private mortgage. The rate will then change when it converts to a traditional mortgage.
How Much You Can Borrow on a Construction Loan
When it comes to a construction loan with a conventional lender, you can borrow between 75% to 80% of the finished market value of the property and the building. So, for most, just like with conventional mortgages, you need a down payment or equity of at least 20% to 25%.
Is it Difficult to Get a Construction Loan?
A construction loan is so difficult to get because you need a down payment of 20% to 30%, a credit score of 680 or higher, a general contractor and/or detailed construction plans. You’re also going to need a fixed-price contract for the construction process and proof of income to guarantee you can cover the costs.
How Progress Draw Mortgages Work
With progress draws, the funds are advanced at each draw when your home meets certain milestones. The inspector will verify the work, and then they will issue the next advance. Your monthly payments are based on the interest of the funds that have already been issued, not the total amount you’re approved for.
Most banks and credit unions divide a build into 3 to 5 progress draws during construction.
- The first phase is excavation and foundation. For your first draw, you should receive 15% to 20% of your loan amount.
- The next phase is lock-up/framing. This includes the framing, roof, windows, exterior doors and weatherproofing. Once this is done, the house is considered 35% to 40% complete.
- You’ll receive another installment once the house is 65% to 70% completed. This includes electrical, plumbing, HVAC, and interior drywall.
- The last draw is usually given at completion. This includes the final finishes, paint, kitchen, bathrooms, and occupancy approval.
The main reason this option is available is to make sure there are no construction liens. Since there is no exit strategy once you’ve started building, it’s important that everything is firmly in place. One way to help make this possible is with a quantity surveyor.
Once the construction period is completed, your progress draw mortgage will then be converted into a standard mortgage. The amount advanced to you is now your total mortgage amount.
What is a Completion Construction Mortgage?
A completion construction mortgage works differently from a progress draw mortgage. For this type of mortgage, the funds are released in one lump sum after the home is built, and you’ve received legal possession.
The reason this type of mortgage can work is through builder financing. Either the builder or the developer will finance the home’s construction during construction. You usually have to put down a deposit, which counts towards your larger down payment. Once the build is completed, the full mortgage amount is then transferred to your builder.
Getting a Construction Loan for a Self-Build
When you’re looking at a self-build construction loan, it’s important to know that the eligibility requirements are going to be much stronger. You’re going to need a down payment between 25% and 35% of the total project cost or the completed appraised value. You’re also going to need detailed blueprints, land value, strict cost estimates, building permits and a timeline.
As a builder, you’re going to have to prove that you have a contractor’s license, as well as hands-on experience. Even then, it can still be difficult to get approved because there’s a higher risk of delays and budget overruns.
Does CMHC Insure Construction Mortgages for Owner-Occupied Homes?
In Canada, you can get mortgage loan insurance on new builds with one to two units as well as e for larger builds with multiple units (multi-unit buildings), but financing terms are slightly revised.
For residential mortgages with 1-2 units, you can make a down payment as low as 5%. For those with 3-4 units, you can put down a down payment as low as 10%. The maximum lending value for an insured mortgage is $1.5 million.
With construction financing in Canada, even with an insured mortgage, you can still get an initial advance as well as continuing advances throughout the different stages of the build. While your dream home is being built by a professional builder, you will still have to pay the interest costs on the advanced amounts.
In order to qualify with a custom-built home, though, you will need to be enrolled in a recognized new home warranty program or have an occupancy permit/third-party professional report for owner-built or exempt homes.
What’s the Process if a Construction Goes Over Budget?
While receiving the funds when you hit construction milestones can make it more difficult, it’s still possible to go over budget. If you do, you can’t go over the original agreed-upon purchase price (your agreed-upon loan amount). You will either need to provide the extra cash flow out of pocket, reduce the scope of the project, or complete the application process to get a second loan.
Construction Loans Vs Construction Mortgages
While both of these types of loans are often used interchangeably for borrowers, they do have some slight differences. A construction loan is basically just a short-term loan that is meant to help cover the building costs. A construction mortgage is used to secure a property title and provide more flexibility by providing the capital needed to build the home in increments. It’s important to note, though, that the mortgage interest rates and construction mortgage rates will be different.
How Construction to Permanent Financing Works
A construction-to-permanent loan provides both the building funds and the long-term mortgage into one single loan. It will cover the land purchase and the construction phases. It requires interest-only payments during the building phases and converts it into a traditional mortgage once the project is completed.
How to Finance a Laneway and a Garden Suite
If you own a residential property, not a commercial property, and are looking to add a laneway or garden suite to your owner-occupied home, it is doable. Often, it will require you to tap into some home equity in order to make these major renovations to create affordable housing. How much you have access to will depend on your credit score as well as your net worth.
Another option is CMHC-insured secondary suite refinancing. This allows you to refinance with a fixed or variable rate mortgage for up to 90% of the as-improved property value or the completed value. You then have the option to add whatever you like, including energy efficiency, which can be a game-changer when it comes to adding to the value of your home.
