Funding a new build or major renovation: loans, draws and cash flow

How a construction loan differs from a purchase mortgage

A purchase mortgage is paid out in one amount at closing. A construction loan is usually short-term financing for building or rehabilitating a home, and the money is released in several stages as the work moves forward rather than all at once. According to the Consumer Financial Protection Bureau (CFPB), construction loans generally carry higher interest rates than the longer-term mortgages used to buy homes.

How the loan is repaid when the work ends depends on the loan. Some require the balance to be paid in full; some can be converted into a long-term mortgage. If the loan does not convert automatically, you may need to apply for a new loan.

Down payment, rate, the number of draws and what must be submitted before each draw differ from lender to lender, and the terms you are offered also depend on your credit history. When comparing lenders, put these terms side by side on one sheet.

• How the loan is repaid at completion: paid in full, converted to a long-term mortgage, or replaced by a new application
• What must be submitted before each draw, whether a site inspection is required, and how long a draw usually takes
• What you pay each month during construction: interest only, or principal and interest
• Whether the loan can be adjusted if the budget is exceeded or the schedule runs long

Line up contractor payments with loan draws

A home improvement contract that falls under the Massachusetts HIC rules should set out the scope of work, materials, total price, payment schedule, start and completion dates, the parties and their signatures. The HIC rules cover work on existing, owner-occupied one- to four-unit homes, so a new build may fall outside them, but it still needs a written contract that spells out scope, price, schedule and payments.

Tie payments to stages you can see, such as foundation complete, framing complete, rough plumbing and electrical complete, and interior finishes complete, rather than to dates or a phrase like "halfway done". The reason is practical: the loan is also released in stages as the work progresses, and when the two schedules match, you have funds available when the contractor bills.

Before signing, show the lender's draw conditions to the contractor and confirm the contractor accepts that pace. If the contract calls for a payment before the lender is willing to release the matching draw, you will have to cover it yourself in the meantime.

Ask your attorney, based on the contract and the project, what documents to collect with each payment, such as receipts, invoices, and whether lien waivers from the general contractor and major subcontractors are needed. Check that list before each payment, and complete any missing documents before paying.

• Contract payments and loan draws compared stage by stage
• Each payment tied to work that can be confirmed on site
• Attorney's list of documents to collect with each payment
• Payment records, receipts and the matching milestones filed together

Draw inspections and municipal inspections are different jobs

When a lender sends someone to the site, the purpose is to confirm that the reported progress matches the draw request and to decide how much to release. That inspection does not judge whether the work meets the building code and does not vouch for quality.

Code inspections are carried out by the town's building, electrical, plumbing and other inspectors at the stages the permits require, followed by final inspections at completion. Newton, for example, states that old permits do not close on their own: inspections must be scheduled and the closed status confirmed in the city's system. Passing a draw inspection therefore does not close a permit, and passing a municipal inspection does not mean the lender will release the next draw.

The contract quality review is a third job: whether workmanship, materials and dimensions match the drawings and the contract is for the owner, the designer or someone the owner engages to check. Each of the three has its own purpose, and the schedule needs room for all of them.

• Who performs the lender's inspection for each draw, and what it covers
• Who schedules each municipal inspection, written into the contract
• All permits confirmed closed in the town's system after completion

Change orders move the price, and can affect the draws

Problems found once walls are opened, or materials changed partway through, are common in major renovations. Any addition or deduction beyond the original contract should go on a written change order stating the work, the price change and the effect on the schedule, signed by both sides before the work is done. The same applies to allowance items: when a selection costs more than the allowance, the difference should be put in writing.

Change orders add up and push the total price higher. Once the total changes, ask the lender in advance whether later draws will be adjusted and whether you will have to cover the difference yourself, rather than discovering a funding gap at the last draw.

• Each change order states the work, price change and schedule impact, and is signed before work starts
• A running total of change orders, so you always know where the price stands
• The lender told promptly of significant price changes, and the draw arrangements confirmed

Cash reserves and living costs during construction

Major renovations and new builds often run into rising material prices, late deliveries or problems hidden inside walls. Keeping your own cash reserve outside the loan, separate from everyday household accounts, means an expense outside the contract does not stop the work while you look for money. How much to set aside depends on the condition of the house and the complexity of the work; your designer and contractor can help identify where the uncertainty is greatest.

If you cannot live in the home during construction, the cost of living elsewhere belongs in the plan: short-term rent and deposit, moving, storage, and the extra rent if the schedule runs long. None of this is in the construction budget, yet it is often where the cash pressure comes from.

Then there are carrying costs: property tax and insurance that continue during construction, interest on the construction loan, and any existing mortgage. Putting these on the same month-by-month sheet as the construction payments shows in advance which month will be tightest.

• Baseline budget before work starts: contractor's price, known changes, your own reserve
• Monthly carrying costs: loan interest, property tax, insurance, existing mortgage
• Temporary living costs: rent, deposit, moving, storage, and the case of a longer schedule
• Payment and change log: amount paid per stage, documents, running change total