Building a custom home suited to your exact needs is most people’s dream. When house prices are high or even unaffordable, we start to look for ways to get into the property market at a lower cost than purchasing an existing home or from a suburban developer. This is very true today, and construction mortgages can help you to meet your property goals, but their details and risks are fairly unknown to most of us. The purpose of this article is to look deeper into construction mortgages so we can understand the details and the many risks associated with them.
What is a construction mortgage
A construction mortgage is mandatory whenever a borrower wants to alter the profile of their property in such a way that their mortgage lender’s covenant may be affected. Real estate loans are secured against real property. Hence, lenders require their consent before you carrying out construction work on your mortgaged property. To protect their loan security, mortgage lenders use the control mechanisms of construction mortgages to give them the best chance that construction projects will be completed. What construction activities warrant a construction mortgage, and which are deemed renovations or improvements:
- Any activity affecting the lender’s loan security.
- Building a property on green land or demolishing a property in any way to alter, rebuild or build a new property in its place.
- Changing the square footage of a property
- Removing the roof off of a property.
- Changing the property’s profile.
- Structural changes.
These construction activities can generally be complete without consent from the mortgage lender and from mortgage proceeds such as an equity take-out or a Home Equity Line of Credit [HELOC]
- Cosmetic changes. E.g. changing the flooring from carpet to hardwood, kitchen renewal, finishing a basement, etc.
Types of Construction Mortgages:
Construction mortgages can be obtained from prime lenders or dedicated construction mortgage lenders. Each type of lender has its own criteria with its unique benefits and disadvantages. Here are a few characteristics of each lender type:
These lenders typically provide one and the same mortgage for construction and post-construction.
- The construction mortgage becomes the final mortgage, so only one mortgage is required.
- Although the mortgage rate may be higher, the mortgage is typically still at a lower rate than a construction mortgage lender’s rates.
- Very few and an ever-diminishing number of prime lenders do construction mortgage financing.
- The mortgage terms are more limiting and very restrictive.
- The lender may require the borrower to contribute additional equity to the project from their resources.
- Pay interest on the entire, as a complete mortgage, from the beginning.
These lenders specialize in construction mortgage financing and have very well-defined programs for various project types.
- Specialize in construction mortgage financing
- Multiple construction mortgage programs
- A lot more flexible with their terms & conditions.
- Allows borrowers to draw funds when they need to
- May lend in geographical areas where prime lenders don’t conduct business.
- Only pay interest on the funds drawn for construction
- Interest-only payments during the construction projects
- Take-out financing is required upon completion of the construction project.
- Interest rates are higher.
- Lenders change fees.
Now that we know a bit more about construction mortgages, it is important to note that construction projects and thus, by association, construction mortgages, are of the riskiest mortgages you can take on for at least the following reasons:
- Project Creep: Construction projects are notorious for going over budget. What if you don’t have any additional funds to cover those costs?
- Timebound: Construction mortgages are short-term by default because the lender wants to ensure that its security is completed as soon as possible. What happens when your project misses important milestones or goes past its due date?
- Contractors: What if your contractor does not show up for work, or doesn’t complete their work or does poor work? What if your contractor gets into a dispute with you and places a lien on the property upon completion?
- Construction Draws: What if your project misses a milestone and you have to inject your own cash into the project before your lender allows the next draw in funds?
What if the appraiser under appraises your project and your lender denies or delays your next draw?
- Take-out Financing: What if, for whatever reason, you are unable to qualify for your take-out mortgage financing once your construction project is complete?
- Permits: What happens if the city does not want to sign off on your project or any part of it.
- Financial Hardship: Construction projects have a high probability of causing financial hardship if any of the above or other factors occur.