Finance or Not: Many clients embarking on the journey of building a custom home seek to finance their dream through a construction loan. With numerous high-street and non-high-street banks and credit unions offering these financial products, it’s essential for clients to consider a few key factors from the contractor’s perspective when choosing a lending source.
Naturally, the interest rates and terms offered are primary considerations when selecting your lending source. However, there are other critical matters that can significantly impact the construction process.
Let’s start with the deposit. The deposit serves to fund the initial stages of the project, covering work to be carried out and materials to be purchased up to the first draw. Many lenders will arbitrarily give a 10% deposit. What if this is not enough?
If the contractor lacks adequate funding from the bank, they may need to finance the project through other means. This can manifest as lines of credit, which can be costly and will ultimately factor into your construction costs. Alternatively, it may involve diverting funds received from other projects. This situation exposes your project to high levels of risk, akin to being part of a chain where one link’s break can bring your project to a standstill, leading to dire consequences – a scenario we’ve all heard about.
Ideally, you should strive to agree on a deposit that accurately reflects the initial costs, ensuring that construction reaches the stage of the first draw with a positive cash flow. This financial stability is crucial for project continuity.
Usually, the contractor applies for the subsequent draws, identifying what work has been completed and the amounts from the draw schedule that are now due. The bank will send out an inspector to confirm that the work is completed and the application is correct. Once approved, the bank will issue a disbursement to the contractor.
This can take a week, but some banks are not as advanced as others and take much longer. In our experience, the banks with online application processes are the quickest, provided they have multiple inspectors they can call on.
Let us assume that the first draw is paid once the concrete slab has been poured. Now, the contractor has the funds to pay the sub-contractors for the work completed. Providing the sub-contractors for the next stage do not require deposits; they can proceed with construction.
However, about now, the trusses need to go into engineering and fabrication, and the windows need to be ordered to avoid delays down the line. Truss manufacturers typically require a deposit before engineering and, another before fabrication, another before delivery, and a final payment on delivery. Window suppliers typically require up to 50% before manufacturing, too. Who is paying for these deposits? Most banks do not give advanced payments. Some of the more progressive banks will give funds once an invoice is provided.
This may be the same for cabinetry, plumbing fixtures, electrical fixtures, flooring, etc., or any other materials that are needed to be purchased before the bank’s inspector can see them installed.
In custom home construction, change orders are practically inevitable. Provided you have planned the project well, these will be controllable. However, the key question is, where does the contingency funding for these changes come from – the bank or you? Most contractors will need change orders to be paid for upfront (or, again, the contractor is financing the project), which is typically in the short term.
To overcome these financial challenges, it has become common practice for many contractors to front-load the draw schedule. Which, in theory, will provide a positive cash flow, but it also exposes the project to higher risk. In this scenario, the contractor is holding funds that have yet to be spent on your project. How are they handling those funds? Are they secure? Do you know what amounts they have and what they have spent on what?
In the event of an issue, do you have a clear process to recover these funds and determine the owed amount? You don’t want these financial details to be scattered on a dashboard like a collection of random receipts.
In summary, you do not want the contractor to be funding your project. This is not what they are good at. Hence, you need a bank that is willing to ensure the project has a positive cash flow.
Additionally, it’s imperative to have a clear paper trail of the funds received, invoiced, and spent. Treat it as a business transaction, complete with balance sheets and profit and loss statements. If your contractor can’t provide this level of cost management, you’re exposed to unnecessary risks. Your project’s finances should be transparent and readily accessible on an ‘open-book’ basis.
Not financing the cash flow of the project can lead to delays and higher construction costs, which might outweigh the additional interest on a loan with a slightly higher rate. Do the due diligence on your lender and their processes. Ensure they will actually finance the project.
Provided by Simon Amesbury, Partner | Alair South Tampa