How Construction Mortgages Really Work

Are you planning on building a home? If so, there are a few things you’ll want to know about your mortgage financing. Construction mortgages are unique in many ways and it can be a very frustrating process if you don’t understand how they work. Because they are not a common type of mortgage, many mortgage lenders are unfamiliar with all the details. I’ll help you out in this post with tips and details on exactly what to expect.

Construction versus Completion Mortgage

First, let’s be clear on the difference between a construction mortgage that requires financing in stages versus one where the builder finishes the project and you pay upon completion. The difference in how the mortgage works is significant!

Completion Financing

This is a mortgage where the builder finances the project as the home is built. It’s very similar to buying an existing house and it’s much easier to get a mortgage for a completed property. There are few extra conditions your lender requires, such as you will need to provide the plans and specs, have a confirmation of the New Home Warranty, and when it comes time to finalize the mortgage, you’ll need to provide a completion certificate. These are all things your builder can provide.

Another difference is that the property valuation is based on the plans and specs provided by the builder, so it’s an estimation of the value upon completion. This is important to remember if you end up making any significant changes to the plans and costs. In this case, you’ll want to make sure you update the information with your mortgage lender so that the approved mortgage amount can be revised. It’s best not to leave this to last minute when you are finalizing your mortgage.

The other significant difference is the rate guarantee. Typically, when you get a mortgage pre-approved the interest rate is guaranteed for at least 90 days. When you’re building a home, it’s unlikely to be completed within 90 days so the interest rate will expire. There are some lenders or builders that have extended rate guarantees so make sure you check out how long you can get the rate guaranteed for. A lot can change if it takes a year to get the house built.

Rate guarantees can save you money! Read my post on pre-approved mortgages to learn how rate guarantees work and how to manage them.

Construction Mortgages

This type of mortgage is what you’ll need if you are doing a self-build and require draws while the property is being constructed. You may be doing some of the work yourself, contracting it out in pieces, or having a builder do the bulk of the construction. The big difference here is that you, not the builder, are financing the house as it’s being built. Let’s walk through the process.

Steps to Getting a Construction Mortgage

I’ll start with what you need to get the mortgage approved. In addition to the standard stuff for getting a mortgage, you will need plans, blueprints, and detailed cost estimates. You won’t have an offer to purchase for the house, but you will need one for the land. If a builder is doing all the work and handling the contracting, they can provide the cost estimates. For any pieces you are directly contracting out, you need written quotes (usually 3 separate quotes) for each portion. And if you are doing some of the labor yourself you can factor in a cost for “sweat equity.” Your mortgage lender will use this information for the house valuation so it needs to be very detailed. Make sure to communicate any changes to the construction costs.

TIP:✅ Get your mortgage approved for a higher amount than you think you need. When you start to draw funds later, the draw amounts are based on the approved mortgage amount, not just the cost of the house. More on this below and you’ll see why it makes sense. You don’t have to draw the full amount later, so you’ll still only end up with the mortgage amount you need. Trust me on this one!

You’re Approved for a Mortgage – Now What?

Great! You’ve now got a mortgage approved. Understanding how your funds are advanced will make a difference in how prepared you are for what comes next.

Construction mortgages are advanced in draws as the building progresses. Every time a stage in the building is complete, an interim appraisal/inspection will be ordered. Yes, you will need to pay for each inspection, and for a final appraisal. When the lender receives the appraisal, they will advance a draw based on the percentage completed.

Progress Draw Stages

Most lenders allow for 4 progress draws during the construction. Any additional draws require authorization. Make sure to have your mortgage lender provide you with the specifics in writing. Here are typical draw stages.

  1. Foundation Completion. Minimum of 15% complete. The excavation and foundation are done. The first draw will also include the cost of the lot.
  2. Exterior Finishing. Framing, doors, windows & roof are complete. Approximately 40% complete at a minimum.
  3. Interior Finishing. The drywall is complete and plumbing and electrical roughed in. This is about 70% complete.
  4. Final Completion. The house is at least 95% complete. There may be landscaping and final touches to be done, but it’s complete enough to move in.

For a self-build mortgage, it’s up to you to let your mortgage lender know where you are in the construction process and advise them when an inspection is required. They will request the inspection, but it’s up to you to let them know when to do it.

How Much Money Do You Actually Get With Each Progress Draw?

This is where things get tricky. Let’s say the cost to build your home is $700,000 plus $100,000 for the lot. Your first draw includes the cost of the lot. When you look at progress draw 1. above, how much money do you think you will get for this advance? 15% of $700,000 = $105,000, plus the land purchase of $100,000 = $205,000. Sorry, no. The calculation is based on the cost less the down payment. Have another look at my tip above! This is why it’s so important to have a high mortgage amount approved.

If your mortgage is approved for $720,000, then you’ll get around $166,000 for the first draw. If your mortgage is approved for $640,000, then you’ll get about $148,000. So the amount you receive is directly related to the amount of mortgage that you have approved. In addition to that, there are lien holdbacks of 10%. This means that when the mortgage draw is sent to a lawyer, they are required to holdback 10% of the amount until the building is complete.

With the first progress advance you’ll start making interest payments on the amount borrowed. Regular payments won’t start until your mortgage is fully drawn.

Have Cash, a Credit Line, or Both

When you look at the above example you can see that you get far less money with each draw than you may think. What does this mean for you? Well, you have material costs and contractors to pay as the build progresses. In some cases you may be able to negotiate 30 day terms for payment, but some things will need an immediate cash outlay. And builds don’t always progress on schedule so if you’re waiting for the next draw to pay your bills, you could be waiting longer than you think. There will also be cost overruns. I don’t think I’ve ever financed a home where the build didn’t go over the initial cost estimates. Just plan for an extra 10% and then you won’t get stressed about it when it happens.

Bottom line is, you need access to cash along the way. Be prepared to spend some of your hard earned savings up front or have a line of credit in place that you can draw on. You can pay it off with the mortgage proceeds once the build is complete.

Final Draw

When your home is about 95% complete a final inspection can be done and you get your full mortgage. Your final mortgage amount can be for any amount up to the amount approved. Once it is advanced you can pay off all the contractors and any credit balances. Whew!

Rate Guarantees

Rate guarantees work a bit different for construction mortgages. Rarely is a home built within 90 to 120 days, which is a typical rate guarantee period. Here’s the good news – your interest rate will be guaranteed as long as you get your first draw within 90 days. If it takes another 6 months to build your home, that’s okay, your interest rate will stay in place. The rate and approval won’t last forever though. If your home build is taking too long your lender will need to refresh the approval and the rate.

Mortgage Insurance

It’s a really good idea to have mortgage life and disability insurance in place while the home build is in progress. You don’t want your family/partner to get stuck with a half built house if something unforeseen should happen. Your full mortgage payments start only after the final draw so you won’t pay full premiums during the construction. When you finalize all the details you can cancel it if you no longer require coverage.

Stress Reducing Tips

As you can see, a construction mortgage is a little more complicated than regular home purchase financing. Here’s a summary of tips to make it easier for you.

  • Deal with an experienced mortgage lender. This is not the time to be working with someone who has been on the job a year. Construction mortgages require some expertise – interview your lender and make sure they are familiar with the process.
  • Get the details in writing. As with any preapproval, you want to have the mortgage amount, rate, and terms in writing. In addition, get a breakdown of when each of the progress draws will be allowed. Also, get the specifics about how long the mortgage approval is good for and how long the rate is guaranteed.
  • Keep in touch with your mortgage lender. It’s not fun if you are ready for a draw and find out your lender has left the company, or they’re on vacation for the next 2 weeks. There could be delays if someone else has to pick up your file and sort through it. Shoot off a quick email a week before you think you’ll need a progress advance to let them know you’re going to be ready for a draw.
  • Have your mortgage approved for a higher amount than you’ll need. You’ll need to find the right balance for this. If you have less than 20% down payment you need to pay mortgage insurance premiums which can add up. Here’s a premium calculator to help you run some comparisons.
  • Manage your rate guarantee. If you know you aren’t able to get a first draw within 90 days then talk to your mortgage lender and have them refresh the rate. This post explains more about rate guarantees.
  • Expect cost overruns. They are a fact of life when you build a home. Before you make any significant changes to the plans and costs talk to your lender to make sure the mortgage amount can be increased if necessary.
  • Have access to cash and/or a credit line. Things will go much smoother.

Do you have experience building a home? Have comments or questions? Please share your thoughts.

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