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Time Is Money:
Demystifying Disbursement of Construction Financing
Kevin J. Daum
This article was originally published in the May 2005
edition of Log Homes Illustrated magazine.
Unless you have built a home before using a construction
loan, the process of getting money to pay for your project
can be a bit of a mystery. Many people simply expect the bank
to give them a big chunk of cash as soon as the loan is funded.
Of course, that would be somewhat risky on the bank’s
part. Oddly enough, banks are not inclined to trust that you
and your contractor will get all the work done on time and
on budget if given all the money up front. In order to protect
their interests, the banks have designed disbursement systems
that allow you to draw money as needed, with checks and balances
in place to make sure the risk is minimal.
Banks are at their greatest risk with construction financing
while the project is in mid-construction. The bank commits
to lending an amount of money based upon the home’s
markt value, but until the property is finished, they can’t
recoup their money if you default on the loan. Projects in
mid-construction are harder to sell than finished houses or
vacant lots, so the bank wants to make sure the project is
financially sound every step along the way. Construction projects
in process also have the risk of potential mechanic’s
liens. Mechanic’s liens are the contractor and sub contractor’s
weapons to ensure they get the money due them. The contractor
can actually attach a lien to your house that requires payment
before the bank gets its money if you default.
To protect their investment, the banks structure construction
loans like a giant credit line. The bank allows you to draw
money off this line as work is completed. The bank uses a
voucher system or a draw reimbursement system to assess the
progress of the project and give you the dollars. Both systems
will make use of a cost breakdown that will be a detailed
estimate prepared by you and your builder during the construction-loan
process. Most banks use the voucher or the draw reimbursement
system, but sometimes you have a choice. Here are brief descriptions
of both systems.
The Voucher System
The voucher system was the primary method of disbursement
for decades. The banks liked this system because they retain
tight controls over the money that gets released. The bank
issues vouchers, which looks like oversize checks made out
to each supplier and subcontractor based upon the exact amounts
listed in the cost breakdown. On the back of the voucher is
a bunch of legal mumbo-jumbo releasing the interest of the
sub or supplier.
You or your contractor give the vouchers to the suppliers
and subs to be redeemed when the bank is provided with adequate
proof that the materials were received and the work is done.
At this time the sub or supplier must sign the voucher releasing
any claims to the property. They also may have to provide
additional invoices and paperwork supporting their costs.
After inspecting the property for completion, the bank redeems
the signed voucher with a cashier’s check.
The voucher system can be an excellent system for projects
that need tight budgetary controls. Many times a bank will
require a voucher system if the contractor has questionable
credit or finances. Vouchers assure both you and the bank
that no one gets paid without clearing the project of any
lingering financial liability.
The biggest complaints about the voucher system are that
it requires a lot of paperwork moving back and forth. Since
it requires everyone involved signing every voucher, a traveling
owner can make for a logistical nightmare. Also the voucher
system allows for minimal wiggle room on the numbers; the
project can come to a grinding halt if estimates are far off
the reality of the costs.
The Draw Reimbursement System
This is the most common disbursement method and is gaining
in popularity. Many banks have switched to the draw system
because it is easier to manage and keeps the project moving
at a steady pace. Unlike the voucher system, the draw system
requires that you manage the funds and ensure payment, as
well as the releases from mechanics liens.
Here’s how it works:
- The bank will use your cost breakdown as a guide for how
much each item costs in labor and materials.
- The bank will establish a specific draw schedule. This
may be five to seven times during the construction loan,
or it could be every month or every two weeks if the bank
allows.
- You front the money to the subs and suppliers for any
work completed to date.
- At the designated time in the draw schedule you and/or
your contractor will fill out a form and fax it or fill
it out online specifying which line items have been completed
or partially completed.
- The bank sends out an inspector to confirm that you have
completed the work for the portion of the construction for
which you are requesting reimbursement.
- Upon confirmation from the inspector, the bank wires the
entire amount of the specific line items regardless, of
actual cost, to an account that you and your contractor
have previously designated.
- The lender protects itself against mechanic’s liens
by having the title company issue an endorsement to the
title insurance policy.
Most of the time the draw system works effectively. It is
much faster and simpler than the voucher system because the
bank is paying a lump sum to one account without requiring
a lot of paperwork and signatures. Most draws can be funded
in a few days from start to finish. Soft costs such as architecture
and permit fees can be reimbursed upon receipt without inspections,
so you can get your money faster.
The biggest challenge in working with the draw reimbursement
system is the need for up-front cash on your part. Depending
upon your draw schedule, you may have a lag time of two weeks
to a couple of months before you can request reimbursement.
Since most subs and suppliers don’t like to be put on
hold for their money, you need to be able to pay them out
of your own pocket in order to keep them happy.
Also, there can sometimes be disputes with the inspector
as to how much of the work has been completed. For example,
suppose you request 50 percent of the $20,000 plumbing line
item. The inspector comes out and reports to the bank that
in his opinion you are only 30 percent complete with the plumbing,
so the bank only gives you $6,000 instead of $10,000. This
shortfall is only a temporary one since the bank will give
you the entire remainder when the plumbing is 100 percent
complete. Still, situations like this can wreak havoc with
your cash flow.
Remember that the bank will only pay you the amount on the
line item; so if the real costs are lower, you will get extra
cash. However, if the project costs are higher than the line
item estimate, you will have to make up the difference out
of pocket. The best way of protecting you against cash-flow
and cost over-run issues is to remain liquid during the construction
process. Here are a few tips:
- Don’t pay off your lot unless you absolutely have
to. The cash will be more helpful to you if it is accessible.
Cashing out equity is a lost cause once construction has
begun.
- Take as big of a construction loan as you can. You don’t
know what the house is going to cost until it is finished.
Borrowing too much money is much safer then borrowing too
little and running out of cash. Any overages in the early
draws can be used to fund the later parts of the project.
- Use a credit line or refinance your current house to advance
the draws until reimbursement takes place. Your existing
house will likely be sold when you are finished, so there
is no reason not to borrow the equity on a low-payment Adjustable
Rate Mortgage (ARM) to help fund the project at hand.
- Use credit cards as an interim funding source. We all
agree that abuse of credit cards is a bad thing, but you
have the perfect use for them in a construction project.
Since it’s unlikely you will go longer than 30 days
without a draw, you can take advantage of the 30-day interest
free grace period that most credit cards offer. When you
get the draw, simply pay off the card. If you use airline
cards to fund this process, you could be sitting with hundreds
of thousands of points at the end of the project to use
on a much-deserved vacation when the house is finished.
Dealing with Deposits
Most banks willing to loan on Log Homes are generally familiar
with the need to cover deposits before the logs are delivered
or put in place. It is always in your best interest to ask
up front about how they handle these deposits in their disbursement
process. Not all banks will forward the money directly to
the log-home company. Some will want you to cover any up-front
deposits and reimburse you when the logs are delivered to
the site or possibly when they are stacked. Other deposits,
such as for windows and doors, may also have to wait for reimbursement
until the inspector verifies installation.
Regardless of which reimbursement system you end up with,
you want to arrange a standard process for paying your contractor.
Some banks will require reimbursements paid directly to the
contractor, and others will wire the money only to you since
you are the borrower. Talk with your contractor about how
the two of you will manage the money. Agree upon the need
for a joint account and who will sign the checks. Find out
if the subs expect payment every week and whether they offer
discounted rates for paying in cash.
Make sure you keep detailed records of all financial transactions
since you will need to document that everything has been paid
at the end of the construction loan. If you run into any conflicts
with the bank, contractor, subs or suppliers, pull out your
paperwork and talk it through calmly and openly. Remember
that everyone wants to see the project finished with everyone
getting paid. The surest way to keep the money flowing on
any construction project is to maintain constant open communication
with all of the parties involved.
Kevin Daum is the Founder and CEO of Stratford Financial
Services, a Real Estate finance and education company, founded
in 1989. Stratford specializes in Purchase loans, Refinance
loans and Custom Home Construction finance and has successfully
financed thousands of clients. He is the author of "Building
Your Own Home for Dummies" (Wiley), as well as "What
the Banks Won’t Tell You." Mr. Daum was an Underwriter
for Plaza Savings and Loan and Key Bank of New York. He is
an INC 500 CEO and has been listed as one the 40 Most Influential
People Under 40 in the San Francisco Bay Area. He is the Global
Chair for the Edison Innovation Program with the Young Entrepreneurs'
Organization (YEO) and is a founding Board member of the Bay
Area Chapter of YEO.
Mr. Daum is a frequent contributor to numerous business
publications on the subjects of Real Estate and Small Business
leadership and speaks regularly on both subjects. He can be
contacted at kevin@stratfordfinancial.com.
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