Unlike a traditional mortgage, a construction loan registered as a mortgage can have some costing elements and terms that are not always obvious and which can come back to haunt you after you’ve agreed to accept the financing and are in the middle of your project.
And unless you fully understand how all costs will be incurred, its easy to pick a construction loan offer that is actually inferior to other offers of construction financing presented to you.
Let me give you an example of a construction loan that on the surface has great appeal, but after closer inspection may not provide the best value to you.
A private lender offers a construction loan of $1,000,000 for 6 months at 9% registered in a second position on the property where construction is taking place.
A competitive offer for a private construction loan in second position would be in the 10% to 12% interest rate range. So on the surface, the 9% deal would appear to be a very good offer.
But after further, review you learn that there is also a 3% lender fee on closing plus a broker fee.
In addition, you have to make monthly interest only payments on the full amount of funds approved, not on the amount of funds drawn. So say after 3 months you have only drawn on 30% of the construction loan, you are still paying interest on 100% of the approved amount on a monthly basis, whether you are actually utilizing the funds or not.
In terms of draw advances, the construction loan will not cover HST so you’re also going to need a separate source of funds to cover sales tax as well.
Finally, the 6 month interest term is likely enough time to complete the project, but if its not, there is a 3% renewal fee to extend the term.
When you add it all up, the effective cost is far greater than 9% and the potential cost gets even higher if you have to apply for an extension.
Yes, the stated interest rate for a construction loan is important, but what’s even more important is the effective rate of financing that takes into account all the costs you’re going to incur.
And because a construction loan is going to be for a short period of time, the difference in interest costs by one or two percent are likely going to be less critical than 1) how the interest rate is calculated; 2) what type of monthly debt service you’re going to have to cover; 3) fees on closing; 4) Draw fees; 5) and potentially extension fees.
Unfortunately, some lenders and brokers sell the stated interest rate hard and write in all the other stuff which, if you don’t pay attention to, can create a lot of additional cost and cash management grief to your project.
In order to do a fair comparison, its best to set up a spreadsheet and do an apples to apples comparison of potential offers before you sign off on a commitment for funding.
The best way to go through the exercise is to work with an experienced construction mortgage broker who can help you quantify all costs and also make sure that the terms and conditions of financing are a good fit for your project.