Some people are happy with the existing housing market options. Some are not. Despite all the differences, both probably need a loan to move into their dream house. A construction loan is the weapon of choice for those who need to build it first.
When you look at the real estate market today — you might think it’s way easier to build your own house. However, not all of us own Disney or play golf with Jeff Bezos, so the majority of Canadians still need a loan to build their home. We’re talking about a construction loan. Here’s all you need to know about it — with all the popular mistakes and ways to avoid them.
What is a Construction Loan
We’ll start from the very basics.
A construction loan (also called a home building loan or a building mortgage) is a way to finance the building of a property for your personal use.
Since Canada Mortgage and Housing Corporation (CMHC) requires approximately 20% down payment, homeowners are required to fund the other considerable 80% of the home cost with an approved mortgage.
A home building loan bears more risks for the lender. Unlike a regular mortgage, construction loans do not have a permanent foundation. The lender takes the risk that the property might not be finished, and the homebuyer may run out of money, leaving a half-completed house that is worth pretty much nothing.
The lender wants to see your house built and ready even more than you do — it means fewer risks for them. That’s why the bank requires you to have a contract with a builder or home designer before applying for a mortgage. The contract should specify the approximate construction cost and the exact start and end dates of construction, and any interior upgrades.
Types of Construction Loans
There are five main types of construction mortgages, based on what the loans cover:
- Owner-builder loan;
- End construction mortgage.
It sounds weird if you see them for the first time, we know. However, it’s not that hard. Let’s talk a closer look at each option:
What is a Single-close Construction Loan
It’s the most common type of home building loan. The bank gives you one lump-sum loan that covers both the construction and your down payment. That’s why they call it single-close — you only need to go to the bank once, sign all the paperwork, and you’re ready to start building. What is Construction-only Loan
If you want to finance the construction of your home but do not yet have a place to live, then this loan is what you need.
You can get one loan for both the construction and your down payment. However, you must still be ready to start building when the bank requires it.
What is Construction-only Loan
In construction-only loans, you have to pay the bank one lump-sum payment for both the center and the down payment in construction-only loans. This way, you can build a house with a single mortgage payment, and once it’s built, you’re no longer required to go to the lender every time a contractor needs money.
Construction-only loans have a few risks. One risk is that the market might change, causing the value of the property to fall. Another one is that there may be delays in construction due to bad weather conditions or labor shortages. Make sure you are prepared for anything.
What is Renovation Loan
The renovation loan covers all the work at once, so it’s more flexible than a single-close construction loan. However, it’s riskier for the bank.
Usually, with the renovation loan, you can borrow from 10% to 30% of the total cost of a house.
Almost all renovation loans have an “option to purchase” clause. That means that you can buy the property after a few years of the building if you have enough savings to cover the difference.
What is Owner-Builder Loan
These loans aren’t available anymore, but they were once one of the most popular options. If you already had a house and wanted to build an addition, an owner-builder loan was a way to do it.
The owner-builder type of construction mortgage is easier to repay as the repayment schedule takes place over a longer period.
This type of loan can be repaid in your own time without any problems, but the loan terms are usually linked to the house sale’s price.
What is End Construction Loan
It’s the newest available type of construction loan in Canada. As the name suggests, you get one large lump sum at the end of the building process. The great thing about end construction mortgage is that you don’t have to pay a lot of interest. The lender covers the interest for a certain period, buying you time to move into your new house and start paying them back.
How to Get a Construction Loan in Canada — Step-by-step Guide
Here’s how to get a home building loan:
1. Locate the Builder
Many people are somehow confused about this step. If you’re looking for building materials, you’re supposed to ask for advice from a contractor. The same rule applies to finding a home builder. Construction loans require the bank’s prior approval of your contractor, so your builder should be ready to provide customized solutions to suit your needs.
Additionally, it’s unlikely that the bank will give you a loan if you don’t have an architect or designer on board. Requirements vary from one lender to another, but usually, you need to have a fully designed and detailed blueprint of the house.
2. Request a Pre-Approval for a Construction Loan
It’s best to ask your lender about pre-approval instead of simply applying for the loan. A pre-approval is nothing more than a promise from your bank — if you can prove that you’re ready to build, they will lend you as much as they can afford.
A pre-approval is simply a promise from your bank that if you can prove that you’re ready to build, they will lend you as much as they can afford.
It will cost you nothing, but if anything goes wrong with the inspection of your house plan, the whole building project will be stopped before it even begins.
3. Draw up a Contract with a Builder
As soon as the bank gives you the pre-approval letter, it’s time to draw a contract with your builder. The contract with a builder will determine the type of loan you get. If you want an owner-builder loan, for instance, your contractor should have experience in doing so, and they should give a detailed description of what materials they will use and how much it will cost.
Get ready to show all receipts related to the construction process to your lender — they DO look at them. Your documents must be legible and accessible at any time.
Include the costs for furnishing later on since this can make a significant difference when calculating your profit margin. Constructing a house takes time and patience, but it’s worth it in the end!
4. Apply for the Construction Loan
The last step is to submit your application to the bank. The lender will look over all your documentation once again, and if they’re satisfied with what they see, they’ll approve your loan.
The application process for a construction mortgage is fairly simple, and the lender does not require a great deal of documentation or information to approve any given request. All you need to do is submit your application and wait for a response from your bank.
It’s important that you don’t apply for a home building loan more than once. If you do, your bank will record each application, and your current approval may be revoked.
5. Sign the Contract
When your construction lender approves your construction loan, it’s time to sign the contract with your home developer. The contract should specify everything about the build, include approved building plans and materials, design details, and so on.
6. Start Construction!
Now is the time to talk to contractors about what they can offer you in terms of quality, price, and delivery dates. Make sure that your contractor is experienced enough to carry out the project properly. Get a good estimate from them, and once you’re satisfied with the terms, sign a contract with them as well.
7. Make Your Homeowner’s Insurance Claim
Check with your insurance company that your construction mortgage can be used as mortgage insurance for up to 6 months. If your insurance provider accepts the construction mortgage, then you will get your loan approved much faster.
8. Wait for Approval
This is the trickiest part of the entire process. The lender will need to review your builder’s contract in detail to confirm that the house values are sufficient if you have to sell it back in a year or two.
9. Live Your Dream Home!
After completing your home, you can move into it and no longer worry about any payments since they are all paid off when you signed the papers.
Who Can Apply for a Construction Loan?
If you want to understand whether you’re good to go with the construction loan or not — take a look at two major aspects: land ownership and credit score.
Land Ownership for Home Building Loan
The first owners who take this financial instrument will be those who own the land they plan to build on, which is generally the case when you decide to build in an area where there are no construction companies available in construction finance. If you do not own the land, you must first arrange for this and apply for a loan.
What is the Minimal Credit Score for a Construction Loan Approval?
Banks will consider your score when analyzing whether or not to give you a construction mortgage. The better your score, the easier it will be to get approved for the loan. If your credit score is between 620 and 720 (the higher, the better), you should be good to go with the construction loan application.
You can apply for a home building loan even if you don’t have the best credit score, but it will be difficult to obtain, and you’ll need lots of other credit or collateral to help you get approved. You’ll also need a cosigner, which will help you get better deals than those with low credit scores.
What if the bank doesn’t approve the construction loan?
If your loan application gets denied, it may be because banks have concerns about the size of your deposit, or they may think you don’t have enough experience. If this happens, you need to work on these issues before applying for a construction mortgage again.
Why is DTI important to get a construction loan?
DTI stands for Debt to Income. It is an important factor that underwriters look at when reviewing your mortgage loan, especially if you are dealing with a home building loan.
The lower your DTI, the better it is for your loan application.
The maximum DTI ratio that most lenders allow is usually 50%. This means that you can take out a maximum of 50% of your gross income on any given month to pay off all your debts other than the mortgage loan.
Construction Loan Rates in Canada in 2021
The first thing to understand here: the construction mortgage interest rates will continue to rise for several years to come, as long as the industry continues to grow. The average interest rate for 2017 was 3.94%, much lower than in 2006 when it was 9.30%.
In late 2021 you can expect anything between 4,5-5,5% — of course, approximately. It all depends on your loan type, DTI, credit score, sum, the province, the bank, and a million other factors.
More Things You Should Know About the Construction Loans
Homebuilding loans are mostly simple, but there are some details that many people are not aware of. Some of the most important things you should know are:
- The borrower usually puts down a 30% deposit; however, some lenders might require 50%. The actual amount depends on the person’s credit score and other factors.
- Stability is very important while negotiating with the developers! Don’t make any agreements unless all terms are set in stone.
- You need to understand what you can and can’t do during the construction process. Some of the most important things to keep in mind while building your new home include:
- You cannot rent your property while it is under construction
- You should not accept any rent before the completion of the project
- Your lender will not provide any protection if you decide to sell or renovate your house before it is completed, so make sure that builder’s contract includes a clause about this.
- Make sure that the contract with the builder is detailed. It must include descriptions of all aspects of the construction process, materials to be used, approximate timeframe for completion, etc.
- If possible, get your builder to guarantee his work. This is very important if you plan on living in your home for a longer period.
- You cannot go against the terms of the agreement. The contract should be made in front of witnesses, and you must sign it in front of them.
- If you are having problems with your builder, talk to his supervisor or manager. Don’t always trust your builder himself to help you with any problems during the construction process.
- Interest rates on construction loans are usually lower than mortgages because lenders want to take on less risk when dealing with new structures.
- You should always compare loans when you choose the best one to put your money into. You can do this by looking at various rates and rates of return, income taxes, your credit score, and other factors that will help you assess which financial instrument is better for you.
Conclusion on the Construction Loans — So, Do You Need It After All?
Homebuilding loans can help you build your house if you already have the land and wish to build there. If not, you should consider renting, refining your plans, and getting a loan only after the plan is finalized.
The most important aspect of going through the construction process is that you have a good idea about what to expect in the future. And a construction mortgage can help you deliver on this goal. Another interesting thing about building your house is that it will be worth a lot more if you’ll sell it in five years.