Key points:
- The extent of your home improvement project will determine your route to securing financing. Renovations, extensions, and new builds are all unique.
- Building a new home from the ground up is often the domain of private lenders, which come with higher interest rates.
- It’s important to budget for a much higher final cost than anticipated, as well as a longer timeline.
Talking about construction mortgages!
Today, I want to share a video I recently filmed with Lawrence Mak, a real estate broker based in Mississauga and Toronto. We discussed securing financing for a construction mortgage, specifically for building a completely new property. People often have questions about getting a mortgage for this type of project and what the costs look like, which we address in detail.
Don’t feel like watching? Find the full transcript below!
Lawrence: [00:00:00] Hey everyone, it’s Lawrence Mak here, real estate broker out of Mississauga and Toronto. And I’m here again with my buddy Chris Molder from Tridac Mortgage. Hey, Chris, how are you doing?
Chris: [00:00:10] Good, Lawrence, good to see you. Thanks for having me again. Looking forward to this discussion. What are we talking about now?
Lawrence: [00:00:15] That’s awesome. Well, today we’re going to talk about custom builds and financing for that kind of stuff. Because of the market as it is now, there’s a lot of people who are looking for houses and maybe the inventory isn’t quite there. And so they’re trying to think about the different options for their existing home, whether it’s to renovate it, do an extension, custom build, that kind of stuff. So I wanted to go through the different types of methods that we can improve our own home. And then hopefully you could tell me about the financing for that kind of thing.
Chris: [00:00:42] Gotcha. Happy to chat. So I think it’s important, Lawrence, that we categorize maybe three types of of renovations. Right?
Financing a home renovation
Lawrence: [00:00:52] Yeah. So the first one would be, for example, maybe I wanted to renovate my basement or my home, I mean, or my kitchen. That would be like the first one. The second one I hear a lot is they want to do an extension, for example, you want to build above the garage or maybe you want to just have an extension at the back. So that’d be the second one, and the third one would be the full-blown, I want a custom build. So then we’ll talk about, you know, whether we want to get a vacant lot or maybe our existing home. So let’s start with “I want to renovate my kitchen.”
Chris: [00:01:20] All right. So this is the simplest one. And if you already own the home and you don’t have cash available, then the easiest way to do this is via a secured or unsecured line of credit. So you would go to the bank, apply for the line of credit. They would, based on the amount of equity available in your home, they would extend financing to you and that would be suitable to to finance a kitchen reno anywhere between 50000 to 100000 dollars, whether it’s the kitchen, bathroom, basement, painting, flooring, windows, that kind of thing. So that’s a very simple, very common way of starting renovations.
Refinancing and Purchase Plus Improvements
Chris: [00:02:08] Another option also is if you have an existing mortgage, you can refinance your mortgage to increase the amount. And in doing so, I think that not everyone appreciates necessarily that when you do a refinance, there’s an amount that you own – owe, I should say. But if you borrow more money, you actually receive that money as cash. So you can access the equity through your mortgage and receive cash to finance these things. And I’ll also mention one other thing. If you are buying a new home and you have a limited down payment, there is a mechanism or a product called Purchase Plus Improvements available from lenders, which allows you to finance certain renovation costs when you acquire a new home like kitchens, bathrooms, basements, these types of things.
Lawrence: [00:03:01] Oh, that’s pretty good. So if I buy a new home and I really don’t like the flooring and I need to renovate the basement or something like that, so now there’s a certain package that you can do, certain financial type of help there.
Chris: [00:03:12] Yeah, that’s right. Because when you’re buying, you want to have a certain threshold of down payment, for example, 20 per cent down to avoid the high ratio mortgage insurance. So if that’s your budget, you don’t want to put less down and hold on to cash to do those renos because then it’s high ratio. So through this Purchase Plus Improvement program, you are able to purchase with your 20 per cent down and then extract some additional money from the lender about 40 to to 80,000 dollars to do these reno expenses.
Lawrence: [00:03:48] And you can also, I guess, just get like, could you get like a regular loan for this type of project as well?
Chris: [00:03:53] You can. But when we say regular loan, we have to define exactly what we’re talking about. But if it’s a a line of credit for, say, a secured line of credit, that’s the cheapest money you’re going to find. You’re capped at 80 per cent of the market value of your home. So if you’re buying a new a new place with 20 per cent down, there isn’t enough equity for you in order to get a secured line of credit from your lender.
Lawrence: [00:04:21] I got it. But if I wanted to upgrade my kitchen and refresh that, the the cheapest method for that would be to refinance my mortgage, followed by getting a line of credit?
Chris: [00:04:30] That’s correct. Yeah, that’s correct. The reason you don’t necessarily want to refinance your mortgage, though, is because you have to pay a penalty to exit early. So it’s the type of thing that we talk about usually when your mortgage comes up for renewal, we talk about what your needs are for the next five years. And even though you might not be doing the reno tomorrow, we say, okay, over the next five years, do you need access to capital? And we build a mortgage, plus the line of credit. Hybrid product.
Lawrence: [00:05:02] So depending on the particular circumstances, you should talk to a professional like yourself and figure out what makes the most sense. Right?
Chris: [00:05:10] As always.
Financing a home extension
Lawrence: [00:05:11] Okay. So let’s go to number two. So number two is more like an extension. So typically speaking, the examples that I’ve seen would be people either want to do an extension at the back kind of thing to increase the square footage of their house or the easiest like low hanging fruit pretty much would be to build a bedroom on top of the garage. That one seems to be pretty common in terms of an extension. So in terms of financing for that, what would you do to go about doing that?
Chris: [00:05:39] Yeah. So I think it’s important here to to pause and talk about covenants, what we call covenants in the mortgage world. So presumably, if you own a home and you want to do this project, you have some sort of mortgage, existing mortgage financing already in place. And when you have a mortgage, you have made four promises or covenants to your lender and they are: to pay your mortgage on time, to keep your property taxes up to date, to keep sufficient insurance on the property so that if there’s a fire, it can, there’s full replacement value there. And then the fourth one is to keep the property in a good state of repair. And so if you are doing some structural change to your home, whether it be removing the roof and adding a second story or blowing up the back of the house to do an addition, the home isn’t necessarily inhabitable and you have now broken that fourth covenant. So there’s some sensitivity around that. But if you want to undertake this type of project, then the most suitable way to do it is via a secured line of credit on the existing equity in your home. So it’s important for anybody considering this type of project that they establish how much equity is available to them via a line of credit. And again, that is capped at 80 per cent of the market value of your home. So for example, if you have a 1,000,000 dollar home with a 400,000 dollar existing mortgage, you’re going to be capped at an 800,000 dollar total financing on that property, which gives you access to a 400,000 dollar line of credit behind your existing 400,000 dollar first mortgage.
Lawrence: [00:07:34] So in theory, you take the 400,000 dollars to build an extension and then the four, the covenants, whatever that one should be okay? It’s not that major or is that how that would work?
Chris: [00:07:43] Yeah. So you have to assess the risk in, you should be advising the lender of of your intention in practice. Very often though, people do not do that. They embark on the renovation, see no evil, speak no evil. By the time the renovation is done, it’s now improved the value of the home and life goes on. It’s better for for everybody involved. if the lender does find out that work is being done on the home and you’ve now broken that fourth covenant, then becomes an enforceable action that the lender could enforce the mortgage and call it in, which would be very inopportune at that time because it’s quite difficult to finance a house that has no roof on it.
Financing a new home build
Lawrence: [00:08:36] For sure. Quite difficult. So that’s for extensions. And then so the third one would be typical speaking, someone wants to build their own custom home, so they buy a lot in the middle of nowhere, in this case, just like some land. How would you go about financing? So financing land isn’t really doable, right? Like a bank doesn’t give you a mortgage on some dirt in the ground, correct?
Chris: [00:08:58] Correct. Yeah. So financing vacant land is not easily done. It’s not impossible, but it is really the domain of private lenders and difficult at that. So if we are talking about the purchase of a vacant lot and the desire to build, we have to combine it all into one. And the way to start thinking about this conversation is values. So you have the land value. The value of the vacant lot is your starting point, and your end point is the value of the as complete home. Once you’ve built your dream home on that piece of land, there’s a value ascribed to it. Construction financing or construction lenders will finance typically anywhere between 65 per cent to 80 per cent of the value at any given stage from vacant land to complete. Does that make sense?
Lawrence: [00:10:04] Yeah. Makes sense.
Chris: [00:10:06] And so it’s really important to establish what that end value is. We determine then what is, depending on the lender, they will cap the financing at 65 per cent all the way up to 80 per cent. The higher the loan to value, the more expensive the financing, I’ll just mention that. And as the project reaches various stages of completion, for example, that the foundation has been poured, the frame is up, the roof is on, the interior is being worked on, the plumbing, electrical, all these things. As we progress through the stages, the lender will advance money to you based on the completion of that project all the way to 100 per cent complete. And then once the project is 100 per cent complete, you can now go to your bank or any “A” type or conventional type lender to get what’s called take out financing. And you then replace the expense of construction financing with your final mortgage from the bank.
Lawrence: [00:11:09] Okay. So basically the two different types of financing here, the construction company will finance it based on the end product of whatever it is, after which point they’re not really financing you anymore. And then the regular bank will have that. You have to take a mortgage to buy them out.
Interest rates on construction financing
Chris: [00:11:24] Correct. Correct. Yeah, because that construction financing is only designed for one thing, and that is to finance the stages in construction. They’re highly specialized in it. Most scheduled “A” banks don’t accommodate construction financing. They do have construction financing programs, but they’re pretty picky and quite strict about the qualification and the rules around that which make it not, make banks unsuitable for most construction projects. So we usually turn to these specialized construction financing companies, which are essentially private lenders, and because of that, the capital is more expensive at the lower end of the scale. If the loan to value is very favorable, around 65 per cent loan to value, then you’re looking at financing in the 6 per cent range, plus 2 per cent in fees. At the higher end of the scale, 80 per cent loan to value, the financing costs about 9 per cent plus 2 per cent in fees. So it’s quite expensive. And one thing also to mention is that as the project progresses, you actually don’t make monthly payments on that construction financing. It’s actually budgeted as part of the expenses, the same way you have an expense for lumber or labour or drywall. The financing component is also a line item in your construction budget.
Lawrence: [00:12:56] So in this case, there’s no additional mortgage payments or interest payments. It’s just like this giant credit card that just money goes into and then you worry about it at the end of the process.
Chris: [00:13:05] That’s right. It’s definitely accumulating the interest. Interest is accumulating, but that is part of that, you know, take out mortgage. You want to make sure that you are in a position to qualify for that take out mortgage, to pay for all the construction costs plus all the interest costs when you go to your bank.
Lawrence: [00:13:25] Right. So the interest the interest rate, you know, you mentioned maybe 6 to 10 per cent or something in terms of construction loan. And then at the time of this recording, we’re talking maybe about 4 per cent or something is what like a regular mortgage would get you? Yeah. Just as a comparison in case way in the future, an 8 per cent is like oh, that is amazing.
Chris: [00:13:44] You know, I hope not. We got big problems if 8 per cent is normal, but yes.
Lawrence: [00:13:48] Who the heck knows? Right. So I guess the second question is, can I do the construction loan like indefinitely or do I have to buy it out from a regular?
Working with two separate lenders
Chris: [00:13:58] Yeah. The, the, if you can get construction financing from the bank, if you meet all the strict criteria, then the bank then converts that construction loan into the final take out mortgage. But I would say for probably 90 per cent of of the cases, there are two different lenders involved. One is that construction loan or construction financing and the other is that take out. So they’re completely separate. And so for that reason, you would always be needing to qualify for that mortgage the second time round. And that’s one of the the comments that I typically make at this point is that when we evaluate whether you should be doing construction financing, we need to really assess whether you qualify for that final take out mortgage from the bank because the construction financing, the construction lender is going to lend you money to do the work. That that isn’t the issue. What is the issue is that once the work is complete and now you have a 2 million dollar financing that needs to be paid out, do you qualify for 2 million dollars at the bank?
Lawrence: [00:15:17] I see. And then that would be based on the family income and the salary and that kind of stuff to see if you qualify for a regular mortgage at that rate.
Chris: [00:15:25] Correct.
Lawrence: [00:15:26] Okay. That’s very good. So I think that gives a good idea for buying like a vacant land. So the last question, which I get a lot, would be to build on my existing home, because for the people who are looking to do this kind of stuff, typically speaking, you know, there aren’t that many homes that they like, I guess in terms of that would work for their family, whether it’s because of the finishings or you know, or just like the location, that kind of stuff. And so, I mean, let’s put this in as an actual example. You know, let’s just say a family has about a 2 million dollar home. They have a small mortgage on that, nothing big, but they have a lot of equity in the home and they’re looking to build like a the end product would be like a 4 million dollar home, so maybe about 1,000,000 dollars worth of build, that kind of stuff. So what would be the process for that?
Chris: [00:16:11] Yeah. So you want to establish a scope of work. I think step one would be to have a preliminary discussion with the builder to get an idea of what type of budget is involved in building out that dream home just to establish it. And then we would work with a realtor like yourself, Lawrence, or an appraiser to say, as complete, when this project is done, what will the value be of this property with these quality of finish, with this number of rooms? So you want to make sure that the value is there. And then based on that end product, that final value, we can then build out different financing solutions. Presumably you would have an existing first mortgage and we would find some hybrid combination of adding a line of credit that you can draw upon as needed for construction. And/or we can also combine it with some specialty construction financing as a second or third mortgage to get the project complete. Then once the project is complete, we consolidate it all together. Again, I’m going to pause here and just remind the discussion of that covenant detail that we want the home in a good state of repair for the lender, otherwise they can call in your existing first mortgage. So you have to evaluate the risk involved. If you are fundamentally tearing down your home, rebuilding the walls, rebuilding the foundation, then you probably should be seeking proper construction financing. If it’s more of an aesthetic interior project where you’re keeping the existing walls and foundation, you can probably get away with line of credit and not necessarily advising the lender of the extent of the reno.
Lawrence: [00:18:12] Yeah. So if you’re maybe just going down to studs or something like that might be okay depending on what it is. You know, you have the foundation of the roof, everything is okay, just inside, just doing some stuff as opposed to you’re bringing down the foundation, adding some more foundation and then rebuilding back up. There’s no home to finance there.
Chris: [00:18:29] Correct. That’s exactly it. If the music stops all of a sudden and the lender goes, okay, we got to call in the mortgage and there’s no home standing, they will not be very pleased. Yeah.
Lawrence: [00:18:41] So so in this particular case, all the initial process, whether you’re doing the builder or getting plans or architecture or whatever it is, that type of design, is that usually, is that part of the construction financing or is it typically people would start the process, line of credit and just start the process of setting up that package, figuring what the final value is and then going to construction loan?
Once started, completing construction is essential
Chris: [00:19:03] Correct. Yeah. You want to, the initial cost, I think the initial discussion is typically with a builder who can start to establish for you what the hard costs of construction are and the soft costs of construction. And so that would be an out of pocket expense for most people just to get started. And sometimes builders provide free quotes. Sometimes there’s a little bit of of a fee involved. And then beyond that, once we’ve established the scope of work and an approximate budget, we can then make some informed decisions about what type of financing is required. And again, one one key thing to think about is that in addition to the builder’s quote for the the hard costs and soft costs, one of the additional soft costs is the cost of financing in that project. So we want to make sure that that gets built in and that there’s enough room in there for if it’s a 12 month project that the interest cost can be covered during that time period.
Lawrence: [00:20:10] Mm hmm. And so, I mean, what happens if you can’t qualify for the mortgage at the end of the day? Like, you know, you built this thing, then all of a sudden maybe lose your job or your business goes belly up or whatever it is. And all of a sudden you can’t quite qualify as much as you could before. What would be the options at that point? Because the construction loan is done, right?
Chris: [00:20:29] Yeah. Yeah. I mean, once the construction starts, that’s like a freight train. It needs to be finished. Right. Because you can’t you can’t stop halfway through the project because it does nobody any good. That’s very dangerous. So there’s a high incentive to finish the project and work through any issues that arise to complete the project. At the end of the day, with a finished home that is brand new presumably inside and very desirable, if you cannot qualify, then it’s a very simple solution, you have to sell. And so you would list that home of your own accord and try and get top dollar to pay out the construction financing. And if you don’t do that, then the construction lender will do it for you and start to enforce the mortgage via power of sale or calling the loan in.
Lawrence: [00:21:25] I see. So then, so the construction loan, you can’t just hold indefinitely, right? I mean, it’s sort of like, okay, good. I don’t mind paying this interest, you know, the higher interest, but I’m okay with paying this higher interest rate because I can’t afford a regular mortgage. But I can’t just do that indefinitely, right?
Chris: [00:21:39] Correct. There’s a certain point in time where the the construction loan will be called. There is a term attached to it. Very often the way the construction contract, construction loan contract is written is that X time period after completion, they expect to be paid out in full. And again, I mean, most lenders are sympathetic to how life can be complicated sometimes, and will work with borrowers. But it is not designed to be an indefinite form of financing your home.
Lawrence: [00:22:17] Got it. So it’s not really there for, financing that therefore do the construction financing. That’s about it. But then if there’s construction issues in the mill, whether during COVID or like labour shortages or whatever, like, does that affect the loan?
Chris: [00:22:31] It can. So one of the the common clauses in construction financing is that if work stops, then the interest for the money that’s been borrowed up until that point needs to be paid. And so when there have been situations due to COVID, due to supply chain issues where construction has had to stop, and construction lenders are working with their borrowers to establish, okay, can you pay the interest or do we allow it to continue to accumulate? And it also depends on the length of time, because if the construction stops and it’s indefinite in nature, there’s a high risk there. And so the lender would expect payment on the on the borrowed funds. But if it’s a systemic issue where we say, okay, well, this material isn’t available, but, you know, in the next three weeks we expect it to arrive. Typically, the construction lender will be comfortable waiving that that requirement for for accrued interest payments.
Preparing for financial overruns
Lawrence: [00:23:44] I mean, so it sounds like if you’re going to go embark on a custom build, you really want to make sure you have the financial backstop to support unexpected issues. Like if you’re just borderline to afford this, it doesn’t sound like it’s a great idea. Is that correct? Like based on your experience.
Chris: [00:23:59] Contract, you want an abundance of cash available liquid to you for overruns because even though the lender does give you the construction financing, the timing of how and when money becomes available because it’s given to you via progress draws, can, the timing may not line up and therefore you should have some cash available about ten. Usually it’s about 10 per cent of the construction budget should be available to you in cash at all times.
Lawrence: [00:24:33] Yeah for sure. I mean, I was talking with one of my friends who was doing a custom build and he was just saying, you know, every change order that he saw, like they like, you know, so pretty much the budget just kept ballooning because, I mean, they were building their forever dream home. So everything was like, yeah, can we do this? Sure, why not? Right. Higher ceilings. Yeah. Sounds good.
Chris: [00:24:53] Absolutely. Yeah. I mean, and it’s crazy because on 1,000,000 dollar construction budget, what’s 5000 dollars here? What’s 10,000 dollars there? You know, it can get really out of hand quickly.
Lawrence: [00:25:05] Yeah. So based on your experience that you’ve seen a lot of, you know, families that have embarked on this journey of custom builds or that kind of stuff, like any recommendations you can give or like problems that you’ve seen, you know, tips, that kind of thing.
Chris: [00:25:17] Yeah. I mean, one of the things I kind of half jokingly say is that it’s it’s not as glamorous as you see on HGTV. It’s a little bit more complex. Right. Whatever your expectations are in terms of cost and budget, double it. Whatever your expectations are in terms of timing, double it. Right. And and it’s it’s an adventure. It is it’s not a straight line. There are problems that arise that need to be worked through. There has to be a certain level of flexibility. And it’s, it’s not for everyone. And I would say, especially if it’s a couple embarking on this process, which often it is that you’re both on board and comfortable with that uncertainty that comes around doing these types of major projects. You don’t know what you’re going to find or what you’re going to encounter on the way. And so you have to have flexibility and a good attitude towards it and good confidence that you can solve those problems. And again, it’s it’s not everyone’s cup of tea to be dealing with those types of cost overruns or issues that can arise.
Lawrence: [00:26:33] Yeah, for sure. It’s not for the faint of heart. I mean, I’ve talked with a lot of people who have done custom build and the process of like the two or three years or whatever it takes to get it done was very, very painful, although they did like the end result. But you know, I mean, even while I’m building it, besides the financial uncertainty of how much it’s going to cost, you have to like live somewhere else during that time. So whether you’re renting some temporary accommodation for two years or you’re living with the in-laws, it’s not quite stable, I guess, for the household. So that process is really painful. But at the end of the day, a lot of them do enjoy that their final dream home that they were going to live in for the next 20 or 30 years or whatever.
Chris: [00:27:11] That’s right. That’s right. Yeah. And it’s not for everybody. It’s not for everybody. And in the meantime, time is money. So it your, it takes a long time. It can’t be rushed. And in the meantime, you’re bleeding cash for all the reasons that you said. You have to live somewhere else. Interest is accumulating. Things may not go at the speed that you expect, and so it’s going to cost more than you anticipate initially. Always. It always does.
Lawrence: [00:27:40] And also, don’t forget about the HST.
Chris: [00:27:42] Don’t forget it. Yeah. And that that’s another one of those soft costs in there.
Lawrence: [00:27:46] You don’t really think about. Like, it will cost you a million, and HST. Something like that. Well, I think that’s all the questions I have today. Any other final suggestions, I guess, for custom build or for any of these extensions, that kind of stuff?
Chris: [00:28:00] No. I think we covered a lot of it here, a lot of content in this call. And I would say if anybody has any additional questions or concerns about how to finance, the door is always open. I can be reached on my cell. 416 732 8020. Or you can find me on my website. tridac mortgage dot com.
Need more help or information?
Understanding how to secure financing for a construction mortgage can be confusing and even stressful. I’m dedicated to helping my clients comprehend their options, and guiding them through their next steps if they decide to travel down this route.
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