A construction mortgage lets you build a home without using up all of your personal cash. It’s not a simple process, but you’re probably someone who thrives on tackling complex projects and carving out your own space in the world.
You’ve always dreamed of building a home. You get lost for hours on Pintrest or Tik Tok, scrolling through insanely gorgeous custom homes. But you’re not just a dreamer. You save and budget and invest. You’ve probably already completed multiple renovations on your own home.
Friends and family who have built a home patiently withstand your questions and curiosity. You know that building a home is not for the faint of heart. But you’re so ready to check this item off your bucket list!
There will always be stress and uncertainty when building a home. The simplest strategy to finance a home build is to sell your current home, live with friends or family for a year (or rent), and pay for the entire build with cash from the sale of your house.
But maybe you want to keep your current house. Or maybe you would rather not put all of your hard earned cash into one project. You need a construction mortgage, then.
Home decor, flooring, anything DIY is your playground. But mortgages and home loans? Not so much. Where do you even start when looking for a construction mortgage?
By talking to a mortgage broker, of course. 😁 But keep reading. Let’s dive into the basics of getting a construction loan to build your dream home.
- How much down payment do you need?
- How much do you qualify for?
- Can I get a mortgage for the land as well as the construction costs?
- Who’s going to build your dream home?
- What is the construction and funding timeline?
- What are the costs associated with building a home?
- The next “Build Your Dream Home” workshop
- Holy smokes, you read the whole way through!
How much down payment do you need?
You need at least enough to cover expenses for the first 30% of the work on the new build. That means you have to front the cash for municipal services or well and septic, excavation and backfill, foundation, framing, roof, insulation, exterior doors and windows.
Then you hire an appraiser approved by your lender to do a “progress report.” The report is sent to the lender who then releases funds to you.
Except they hold back 10% of the funds because they have to by law. More on that later.
Now, 30% completion doesn’t necessarily cost 30% of the home’s value. Could be more, could be less. You want to make sure you have the cash to pay your contractor for that first stage of work.
Let’s look at some real numbers.
How much cash do I need to build a $500,000 custom home
You have a quote from the contractor saying the full build will cost $500,000. The lender approves you for 95% “loan to value,” meaning you can mortgage 95% of the costs.
Even though most of the construction cost is covered, the lender will not release funds to you until they get a progress report from their approved appraiser saying the home is 30% complete. Once they get that report here’s what the numbers look like:
- Construction cost: $500,000
- Your equity: $25,000
- Mortgage amount: $475,000
- First Draw (30%): $142,500
- 10% holdback: $14,250
- Actual Advance: $128,250
Now, does it cost $128,250 for excavation, backfill, foundation, framing, roofing, insulation, exterior doors and windows? What if it costs more?
This is why it’s important to have a budget ready for the entire project before shovels hit dirt. You’ll know how much you need to pay to bring your home to 30% completion.
Of course, we all know how reliable budgets are… Life happens, supply shortages, labour shortages, prices of materials fluctuate. You will save your sanity (and your finances) if you budget for cost overruns. Most lenders suggest you have 15% of the construction cost ready for cost overruns. Any extra you have ready will save your bacon in the long run.
How much do you qualify for?
If you have plenty of cash ready to start building, the next question is, do you even qualify for the mortgage?
Qualifying for a construction mortgage is very similar to qualifying for any other mortgage. However, lenders are more judicious, discerning… picky… when it comes to construction loans. If someone walks away from a construction project midway through, the lender is left with a half-built home which is harder to sell than even raw land.
Who walks away from a construction project? At least 60% of home construction projects are abandoned, according to one lender I work with regularly. Building a home is a lot of work and many people aren’t ready for it.
But you’re ready. You have cash, a budget and a full quote from a builder. So how do you qualify for the mortgage?
- Keep your debt to income ratio low. Your debt should be less than 42% of your income. That includes property taxes on the new house and heating costs (we use a flat $100 / month for heating). If you’re borrowing money from lines of credit or family members to cover the initial construction costs, we have to factor that in as well. And yes, we still have to stress test the interest rate for a construction loan.
- Have a 40% “down payment” ready. I know I already told you that you have to cover 30% of the work upfront. But again, 30% of the work isn’t 30% of the construction cost. If you have a 40% “down payment” ready, you’re much more prepared for upfront costs, the 10% holdback, and cost overruns for that first stage of construction.
- Calculate your sweat equity. IF you are doing any work yourself on the project, you may be able to calculate the value of that work and use it as “sweat equity.” So when you go to a lender, give them a quote for your time. The value of that quote can be considered as part of your down payment, but only up to 10% of the full build cost.
- Own the land free-and-clear. If you owe anything on the land when building starts, we have to factor that debt into your debt-to-income ratio. Then, funds from your first mortgage advance will have to pay off the land debt first.
- Have a full quote from a qualified, insured contractor. This is like the purchase price for your home. The final cost will be higher because there are always hiccups, and hiccups cost money. But we start with a detailed, itemized quote from the contractor. Then we do a “blueprint appraisal.” The appraiser determines the “as if completed” value of your home based on the land and the blueprints for the build. Between the contractor quote and the appraisal, we use the lower value. Your mortgage will be 80% – 95% of that.
Wait, 95% loan to value mortgage, but I need a 40% down payment?
This trips a lot of people up in the beginning.
You need the cash to pay for the first stage of construction costs. There’s no way around that. But you can get a mortgage that will cover up to 95% of the costs (as long as you qualify for it). So you’ll get money back after all is said and done.
Let’s break this down in an example:
- Total build cost: $500,000
- Up front cash: $200,000 (40% of the build cost)
- Mortgage Loan to Value: 95%
- Mortgage amount: $475,000
- Expenses left to be paid: $300,000 ($500,000 – $200,000)
- $475,000 – $300,000 = $175,000
You put $200,000 into the build up front, but you get $175,000 back from the mortgage.
It never works out that pretty. Construction mortgages are advanced in stages, or “draws.” So it’s more about cash flow as the house is built. You pay for the first stage of construction, then get some money back from the first draw. You pay for the second stage, then get more of it back in the second draw. And so on until the house is complete and you move in!
Can I get a mortgage for the land as well as the construction costs?
Yes, you can. But the lender will require any land debt to be paid off from the first draw. That means that you have to have enough cash at the start to pay off the land mortgage as well as pay for the first stage of work (30% completion).
How much is land worth?
Land value varies wildly. But here’s the deal – what you paid for the land is not how much it’s worth when you build.
An appraiser looks at your blueprints, then compares that to similar homes in the area. Land value plays little into their decision of your home value once construction is complete.
For example, you paid $100,000 for the land. You own it free and clear. The home you’re about to build will cost $500,000 to complete. After comparing your blueprints and lot to other home sales in the area, the appraiser decides that your “as if completed” value is $550,000. Even though you’ve put $600,000 into property in total, you may not get that value back right away.
Of course, the appraiser may fully value your land and come back with a $600,000 appraisal, but that depends on the market at the time.
Also, remember that your mortgage is based on the lesser of the contractor quote or appraisal value. In this example, your mortgage is based on the contractor quote, $500,000. This means the value of your land isn’t even considered for mortgage purposes.
This is why lenders want the land paid off before any construction work starts. Land plays a small role in the value of your home.
Are you building in town or in the country?
Municipal land usually has water, electricity and sewage services ready to go. Rural land probably doesn’t. In fact you’ll have to get a quote to put in well and septic systems as a part of your build cost. Also, rural excavation and backfill will be much more expensive.
Building your dream home in the country is the ideal. Just be prepared for the added expenses of rural construction and rural living.
Who’s going to build your dream home?
There are three choices here:
- You build it yourself (self build).
- You hire a general contractor to build it (contractor build).
- It’s built in a factory, piece by piece and assembled on the land (prefabricated).
Doing the work myself will save money, right?
If either you or your partner are experienced and insured contractors, you may be budgeting to save money on the work you can do yourselves.
That’s totally fair, but maybe not as simple as you hope.
First of all, most lenders won’t allow you as an individual to do more than 50% of the work.
So if you complete the framing, insulation, roof, doors and windows, etc., you still have to hire and manage subcontractors for the rest of the work (foundation, electrical, plumbing, etc.)
Self builds succeed or fail on the borrower’s ability to budget and control cash flow. These are the projects that borrowers walk away from the most. Why? Consider this:
A couple works out their whole budget and project timeline, but then the concrete for the foundation is a week late, which sets back framing. They can do the framing, but the project is already behind schedule.
They planned to have the roofers in a week earlier, but since concrete pushed framing back, the roofers went and found other work and are now tied up for another 2 weeks.
Windows and doors are now 3 weeks behind. The borrower didn’t buy the windows and doors ahead of time to manage cash flow, but now the window company is short on the order and it takes an extra week to manufacture the windows needed.
The borrowers are a full month behind and they haven’t even completed the first stage of construction yet. Delays cost money. The cost overruns become overwhelming. The first draw may not even pay all of the expenses back, which the borrowers were relying on to pay for the next stage of construction. Now they’re stuck.
This may sound absurd, but this is calm compared to some of the other real life situations I’ve seen play out.
Unless you’re used to building houses from the ground up, not many people (contractors included) are ready for the logistical hurdles that it throws at you.
Self building can save you money, but only if you are a proven, top notch project manager. The challenge of building a home is less about putting walls and roofs together, and more about managing people, time tables, and cash flow.
Now, you can hire a general contractor who has lots of experience building homes. And if you are a skilled carpenter, electrician, plumber, etc., then maybe they will let you do some of the work. Maybe they “hire” your roofing company to build the roof, or they hire your team to install all the electrical.
That can potentially save you money and it saves you from being the one responsible for managing the rest of the subtrades and timelines.
Hiring a general contractor to build your home
I know I just painted a super bleak picture about self builds, but I just want you to be aware of the reality I see play out too often.
Hiring a general contractor to manage and the build for you is much less stress than a self build (usually). But that doesn’t mean it’s stress free. It does restrict the number of people you have to communicate with, which makes life simpler.
If you’re hiring a contractor to manage the whole build, what kind of home are you building:
- Custom design
Maybe you went to an architect and hired them to draft up plans for your dream home. This is completely doable. Just be sure that the contractor you hire is experienced with custom builds. They present new obstacles on every project, and if your contractor isn’t good at adapting to unique challenges, you may find yourself in the unfortunate position of having fired your contractor mid-build and looking for a new one. (Yes, this happens.)
Otherwise, you can essentially buy pre-designed models from builders. These contractors are used to building the same models over and over again. They’re fast and efficient because they are prepared for the usual hiccups that each model presents.
Of course, flexibility will always be necessary, but a pre-designed model will present fewer surprises than a custom build will. That being said, maybe the builder lets you alter the design a little bit. That way it feels more personalized. Even though it’s not a fully custom home, you still have a unique space that you had a hand in designing.
Buying and assembling a prefabricated home.
Prefab homes are much more popular now. They’re built in a controlled environment (a warehouse) to a standard of excellence and quality that matches or even exceeds traditional builds.
Because they’re built in a warehouse, there are dedicated labourers available just to build your house. The actual building of walls and roofs for a prefab is usually quicker than traditional builds.
Once the shell is built, it’s trucked in and assembled on site. You know the exact day that your home is being delivered. It’s much easier to schedule electricians, plumbers, flooring, drywall and the rest of the subtrades. Multiple subtrades can install services in one day (although that can happen on a well oiled traditional build as well).
This makes budgeting and cash flow less chaotic. You know exactly what you’re getting and when you’re getting it.
In the end, your home is built to the exact same standard as a traditional build, but with fewer potential headaches.
IMPORTANT NOTE: The prefab company will likely want full payment when the house is delivered. Some lenders will advance the funds in full before the appraiser is sent out, others want the progress report before funds advance. That can make coordinating between the lender and prefab company tricky. If you want to build a prefabricated home, let me know. I’ll know which lenders to go to.
What is the construction and funding timeline?
Step one, how much cash do you have available right now? Is it about 40% of your potential build cost? And do you own the land free and clear? Perfect, let’s keep going.
- Fill out a mortgage application and send all the required documents to your mortgage broker.
Mark down that this is a purchase, but it’s a new build as well.
Make sure to indicate how much funds are ready and accessible. Also make a note about how much you owe on the land, or if it is free and clear.
With the accurate information you provide and the documents you submit, I’ll be able to give you precise answers about how much of a mortgage you would qualify for.
Again, there’s a difference between how much financing you qualify for and how much money you’ll still need to pay for the first stage of construction. Just because I say you could qualify for 95% LTV on a $500,000 construction mortgage, you’ll still need 40% of the build cost ready ($200,000).
- Get a full quote for the build.
If you’re building it yourself, have a budget ready for the entire project with material costs and quotes from subtrades.
Understanding what you qualify for, talk to builders and contractors about what you’re looking for. Remember to leave 15% room for cost overruns when discussing what your final build cost can be.
Sometimes contractors will have everything packaged up in a tidy contract with the full quote, a payment schedule, and other legalese. This can make building a home much simpler for you.
Otherwise, have a full itemized quote for the build, even if there is no contract along with it yet.
- Get blueprints drafted up.
If you’re working with a general contractor, they may take care of this for you. If you want a completely custom house, they may work with you and their preferred architect to get the blueprints right. Or they may have pre-drafted blueprints ready. All you have to do is pick your favourite model.
If you’re building yourself, then find a highly respected architect and work with them to draft up blueprints for your dream house.
- Get a “blueprint appraisal” to determine the “as-if-completed” value of your home.
A lender approved appraiser will come out to your plot of land, take measurements, look at the blueprints, and find comparable homes in the same area for reference.
Lenders will give you a mortgage based on the lesser value of the appraisal or the full build quote.
So if the appraiser values your “as-if-completed” value at $550,000, and the builder quoted you $500,000 to complete the home, the lender will give you 95% LTV on $500,000 (assuming you qualify for that much).
The opposite can happen though. If the appraiser says your home will only be worth $480,000, but the builder quotes you $500,000, the lender will only give you a mortgage based on $480,000, leaving you to come up with cash for the shortfall.
- Shovels in the ground! Start building.
With work started, we’re now into our “draw schedule.” Here’s a rough example of what a draw schedule can look like.
|Draw / Stage Number
|Draw / Completion %
|Construction that should be completed
|30% of funds advanced / 30% complete
|Well and septic (if needed), Excavation, foundation, beams,posts, subfloors, backfill, sheeting, roof and door/window framing
|30% / 60%
|Exterior brick/stucco/siding,doors, windows, rough electricaland fixtures, rough plumbing,heating ducts or pipes, insulationvapor barriers, basement floor &heating equipment installed
|40% / 100%
|Drywall, finished flooring, finished electrical including fixtures, finished plumbing, finished carpentry, cabinets, trim & painting
This is a very basic example of a draw schedule. Most projects require 4 – 7 draws. It all depends on the project, you as a borrower, and the lender.
If your builder has given you a predetermined payment schedule, most lenders are happy to accommodate that payment schedule.
But if you are building yourself, you’ll need to come up with a build schedule and budget accordingly. Work with the lender to schedule draws to accommodate your budget.
- Progress reports and actually getting money at each draw.
In order for the lender to release any funds, they’ll want to see a progress report from an appraiser. Progress reports don’t cost as much as a full appraisal, but you still need to pay the appraiser every time they come to your project.
The appraiser will meticulously mark down how far you come on each section of the project. Then they note your overall completion percentage. If you’ve hit the right percentage for your next draw, the lender will release the funds for that stage of construction. But, if you haven’t completed enough of the build yet, you’ll have to hire the appraiser to come out again once you’ve completed a bit more. So make absolutely sure that you’re ready for the appraiser before you call them.
Another cost and requirement before a draw is released is a lawyer’s sub search. This is where a lawyer will search for any liens placed on your property by the contractors or anyone else. The cost of a sub search varies depending on your lawyer.
Once you have a clean sub search and the progress report notes the right completion percentage, the lender will advance the funds to you.
- 97% complete and getting an occupancy permit.
Once you get a progress report that says you’re 97% complete and the home is livable, you can apply to your municipality for an occupancy permit. If the municipality deems the home livable, you can move in!
With that occupancy permit and progress report, the lender should release the rest of the funds, minus the 10% holdback.
So what the heck is that 10% holdback?
- 60 days after completion, the 10% holdback is released.
By law, a contractor has the right to put a lien on your house if they aren’t getting paid. So, also by law, when building a home, lawyers (or your lender) will hold back 10% of the funds from each draw. 60 days after the build is complete, the lawyer does one more sub search to make sure title is clear of any contractor liens. If all is well and good, you get the last 10% of your funds advanced.
- Start paying normal mortgage payments.
Through this whole process, you’ll make mortgage payments on what you owe at each stage. However, some lenders will calculate your “per-diem,” or interest cost per day based on how much money is advanced. So if your second stage took 6 months to complete, the lender will calculate interest at your per-diem rate times the number of days for that stage. The total interest cost is deducted from your second draw.
Your home is considered complete at 97% completion and you have an occupancy report. You officially close on the mortgage (even though the holdback is still waiting to be released) and you start making normal mortgage payments.
Congratulations! You’ve built your dream home! And you’ve just gone through one of the most harrowing and character building experiences of your life! 🙂
Now, how much will that all cost you?
What are the costs associated with building a home?
Want a comprehensive list of build costs? Download it here, along with a more detailed draw schedule, and a net worth statement you can use to determine your financial readiness for a construction project. Using this template, you can create a budget for your home build.
I call this “Your Construction Readiness Handbook.” Yes, you’ll have to sign up for my newsletter to download the handbook. Anyone on my list already got a download link. So look for that in your inbox if you missed it.
Now, here’s a list of other costs associated with building your home:
- Application Fee
- Some lenders waive this, others charge a 2.5% to 5% lender fee that’s taken off your first draw.
- Legal Fees, including, but not limited to (I hate saying that)…
- Title Insurance
- Title Sub Search
- Admin Fee for Disbursements
- Document signing
- Survey fees
- This only applies when you’re buying land
- Appraisal Fee
- Plus Inspection Report Fees
- Building Extension Fee
- When your project runs over time, some lenders charge extension fees.
Some unexpected costs to account for:
- HST – Everything is charged HST.
- Builder’s all risk insurance – You need insurance in case someone gets injured on your build.
- Fire insurance – fire insurance for a build is different and more expensive than typical home insurance.
And of course, every smart home build works in a budget for cost overruns. It’s recommended that you have 15% of the build cost ready in the background, just in case.
The next “Build Your Dream Home” workshop
Home construction is such a popular topic that I run an in person workshop at least once or twice a year. I collaborate with a realtor, contractor, and construction material supplier for a two hour workshop where you get to ask all of your home construction questions.
If you’re in the North Bay area, click here to find out when the next workshop is and register!
Holy smokes, you read the whole way through!
This post is a monster, I know, but I want you to have the best foundation when starting the home construction process.
If you have any questions, feel free to text or call me any time: 705-358-5635
Or email me: firstname.lastname@example.org
If you want to jump right into a mortgage application, it starts here:
Happy home building!
Sherwood Mortgage Group #12176