Q: Hi Kyle, my wife and I were pre-qualified for a mortgage up to $900,000 by RBC but when we went to them with plans to build a house on a bare lot in Vancouver worth $800,000, they turned us down. The mortgage would have been around the same size as what we were pre-approved for but they said we needed a larger down payment, even though we had 30% down. Is there another lender that might help us? Rich and Colleen

A: Hi Rich and Colleen,

Construction mortgages are much more difficult than your typical home purchase or refinance because of the inherit risks associated with lending on a home that during the construction, is significantly less marketable than your average home. They require much more capital than your minimum 20% down because at each stage, the lender protects themselves and will only lend money based on the value of the home at that time, not the future value. Lenders call this a “Cost to Complete Basis”. This is why you may have heard that construction mortgages are structured in what is called a “draw” schedule. To help understand this concept, I will give you an example of how this may work. I will use the figures that you provided (about a $500,000 land value and $400,000 construction costs). This is how a draw schedule looks with most lenders; it is usually comprised of 4 draws:

–          First draw – land only. Typically 50% – 65% financing of the land value

–          2nd draw – Lockup stage, about 35% – 40% complete. Framing, doors and windows complete. Sometimes, lenders will allow a draw before this stage at around 15% completion once foundation has been completed.

–          3rd draw – 65% completion. Plumbing, electrical rough in complete

–          4th draw – 85% completion. Plumbing, electrical complete, drywall complete.

–          Final draw – 100%

So in your example, let’s take a look at what I like to call the “peak capital” required, which gives us an idea of how much capital is required to qualify for a construction loan and have enough cash to complete. Many lenders will also require a 10% lien holdback for new construction in BC, as well as about 10% for cost overruns. Assuming you qualify for a $900,000 mortgage I will use Scotiabank’s draw schedule in the below example:

Draw % Complete Total Advance to Date % of Remaining Construction Cost to Complete Construction Lien Holdback Required Available Advance Amount **
Start 0% $0.00 100% $400,000.00 $0.00 $0.00
1 0% $0.00 100% $400,000.00 $0.00 $520,000.00
2 40% $520,000.00 60% $240,000.00 $16,000.00 $124,000.00
3 65% $644,000.00 35% $140,000.00 $26,000.00 $90,000.00
4 85% $734,000.00 15% $60,000.00 $34,000.00 $72,000.00
5 100% $806,000.00 0% $0.00 $40,000.00 $54,000.00

 

Based on this graph, we can calculate the amount of capital required to reach each stage:

–          Draw 1 – land purchase. Capital required is $280,000 ($800,000 purchase minus $520,000 land draw). For the purposes of this discussion, I will exclude closing costs like Property Transfer Tax and legal fees.

–          Draw 2 – To get up to lockup, it will require an additional $160,000 (40% x $400,000), so now the capital output is $440,000. Once this stage has completed, you will receive $124,000 back (as they will hold back 10% of $140,000 for lien holdback).

–          Draw 3 – To get to 65% complete an additional $100,000 needs to be put in. Now the capital output is $440,000 – $124,000 (draw 2) + $100,000 = $416,000. After this phase is complete the lender will advance $90,000.

–          Draw 4 – An additional $80,000 in work is necessary to get to 85% complete. Total cash output is now $416,000 + $90,000 (draw 3) – $80,000 = $406,000. Lender advances $72,000.

–          Draw 5 – completion. Lender advances the remainder, for a total mortgage of $900,000 minus lien holdback amount of 10% of the construction cost, or $40,000.

Typically getting to luckup stage will be the most capital intensive phase, so most of the time if I don’t think my clients have enough cash I will do a quick analysis of how much cash is necessary to get to lockup to determine the peak capital required.

Keep in mind, that every lenders construction draw mortgage program varies. TD’s program tends to be a little more restrictive as they ask for the lien holdback and cost overruns upfront, whereas Scotiabank only holds back the lien amount as the draws go out, and don’t ask for cost overruns upfront.

As these mortgages are much more difficult thank your typical mortgage, it is important that you work with someone who understands how these work and which lenders do what, to find the best product available.