“My Home 101” is a series of informational articles answering the questions that face every homeowner from the moment that they decide to purchase a home throughout their ownership.  These articles are written to help readers make the most of their experiences as homeowners, and to help educate those who own homes, who want to own homes, and those who are renting homes.  Palladium Custom Homes, LLC encourages relevant questions and comments in response to these articles.  After all, we’re all learning new things every day!

Question:  My homebuilder offers something called a “Mechanic’s Lien Contract” for financing.  What is it, and how is it different from what builders usually do?

 Melyssa’s Reply:

 To understand a Mechanics Lien Contract, it is important to understand traditional financing in relation to building a new home.  In the traditional model of financing, generally what will happen is that you, the Purchaser, sign a Contract of Sale with the homebuilder of your choice and pay them a deposit.  Builders used to ask for deposits of about $1,000.00 but nowadays the standard deposit required is ranging between 10% and 20% of the total cost of the home.  Your chosen Builder will, upon receipt of the deposit and signed Contract of Sale, go to a bank and get interim financing for the construction of the home from that bank.  By having the Builder get the interim financing in their name, it means that they are responsible for the note and paying interest on the loan during the construction of the home. 

 As the Builder works on the home, they go through the regular process of submitting draw requests.  This means that they send a list of the items that have been completed to the bank and the bank sends an inspector out to the property to confirm that the items have been completed.  When the inspector submits their report to the bank , the bank then issues the funds to the Builder so that the invoices for the completed items can be paid.   Ideally the subcontractors should be paid within a week or two after completing the work.  Unfortunately, part of what led to the recent housing crisis was that builders were in the habit of taking the draws from one house to pay the bills on another, borrowing from Peter to pay Paul, if you will.  With the changes that have occurred since the crisis, this will be much harder for a builder to do on any future homes.

 In the meantime, the Builder is paying interest on the loan, but they only pay on the portion that they’ve used as of each payment due date.  So if your Builder has gotten financing in the amount of $150,000 but has only used $50,000 so far, they are only paying interest on that $50,000.  Once the home is built, the Purchaser gets final funding in the form of a mortgage from their mortgage company.  Final closing is held and the Purchaser pays the Builder the Contract price.  This pays the Builder back for the all of the bills that they paid out, which includes the original note, the invoices from the subcontractors and any interest that they paid the bank throughout the building process.  If they’ve done their job right, it also gives them a margin of profit as well.

 The other thing that happens with the final closing is that the Title Company does a search and issues a Title Policy.  This indicates that there are no outstanding liens against the property from taxing agencies, subcontractors, materials suppliers and so on.  Should a lien come up on the title search, the Title Company can then go to the Builder and demand proof of payment or withhold that amount from the closing funds in order to pay the lien.  This guarantees that you, the Purchaser, are buying a property that is free of any liens against it.

 You may be saying to yourself, “I’ve heard of people who have just walked away from their contracts when they couldn’t get financing.  Isn’t that bad?”  Well, yes, it is bad.  Most contracts have language in them that protects the Builder by giving them the right to sue the Purchaser if they should not complete the sale.  Of course, that is rarely done as it is highly unlikely the Builder will get anything out of a Judgment against someone who doesn’t have the means to complete their purchase contract, and the attorneys’ fees will only increase the Builder’s costs even more.  You should be aware, however, that it IS the Builder’s right to pursue that Judgment in a Court of Law and should someone decide to walk away from a contract, they are risking being sued.

 So the pros of traditional financing include the Builder, not the Purchaser, being responsible for interest payments throughout the construction of the home and having more time to secure financing for the final mortgage (though most banks do require that there be prior approval for the final financing before they approve the interim financing.  Final financing can be from a completely different mortgage provider, however.).  Cons include being liable for the full amount whether you can get financing or not, the potential for losing your deposit money should the Builder close their doors for some reason, and not being able to write off interest until the house has closed and the mortgage is in place.  Also, if you are the kind of Purchaser that just wants a house and doesn’t really want to keep an eye on how your money is being spent, there are advantages to this traditional type of financing.  All that you have to do is sign your Contract, get your financing for the completed house, and sit back to wait for it to be built.

 However, should you be the type of Purchaser who has taken the lessons of our recent economic situation to heart and who wants to know where their money is going, a Mechanic’s Lien Contract may be the way to go.  The difference between this and traditional financing is that you, the Purchaser, get both the interim and final financing in your own name.  As the Builder progresses on the house, they submit periodic statements of expenses to you and you sign off on them.  This paperwork then all gets submitted to the bank along with whatever forms they require, and then the draw procedures discussed above continue.  The bank will send an inspector and upon receiving the inspector’s report will issue the funds to the Builder who will then pay the subcontractors and suppliers after getting them to sign a Release of Lien for each payment.

 A Mechanic’s Lien Contract is a more hands-on approach for the Purchaser.  You not only get to see the physical progress on your home, but you get a running account of where the money is going and just who is doing the work.  It also provides a secondary benefit as each Subcontractor is required to sign that Release of Lien in order to have the funds released to them for each invoice.  What does this mean for you, the Purchaser?  Well, it means that no Liens can be placed on your home for materials or labor.  You will have proof that the Subcontractors have been paid in full for their services.  The subcontractors will be happy because they will have their money, and the Builder will become known within the industry as a company that pays their Subcontractors quickly and in-full.  This can become a great advantage when the Builder needs rush work or warranty work done, and also gives the Builder an edge when seeking out new pricing or subcontractors.

 Another advantage to the Purchaser is that should something catastrophic happen to the Builder or their company (we hope it doesn’t happen, but you never know!), you will still own the property and will be able to hire another Builder to complete the work using the remaining funds from your interim financing and you will not have completely lost your deposit!  With the more traditional financing, should the Builder have to close their doors, the banks that they financed with would then foreclose on the properties and you, as the Purchaser, would be left with no house, and nothing to show for the time that you have spent on your project to that point, not to mention that 10% to 20% that you put down at the time the Contract of Sale was signed.  Of course, the potential for this to occur is much smaller than it might have been two years ago, but it is something that should still be kept in mind, just in case.

 Finally, we come to the question of interest.  As was mentioned above, with traditional financing, the interest is paid by the Builder throughout the construction phase of the project.  When it comes to Mechanic’s Lien financing, the Purchaser pays the interest.  This means that you can begin writing the interest off for your property from the moment that construction begins.  Four to six months worth of additional interest is nothing to sneeze at come tax time!

 To summarize the Mechanic’s Lien form of financing, the pros include having more involvement in the home-building process, the knowledge that your investment is protected should something happen to the Builder, the ability to write off interest throughout the construction process and not just once the home is built, and a stronger assurance that all subcontractors and suppliers will be paid in a timely manner, eliminating the worry that liens will be placed on your property after the fact.  The cons include having to get financing at the beginning of the process, paying interest and being responsible to the bank throughout the entire construction period, and having to regularly be available to sign off on paperwork.

 A lot of Purchasers are frightened of the Mechanic’s Lien Contract because it is different from what they are used to.  It really isn’t something to be frightened of.  The Builder who is offering it to you is doing so in order to increase your protection as well as their own.  As with any Contract or other legally binding document, it is important that you take your time to read it and be sure that you fully understand it, but don’t let it intimidate you, simply read all of the documentation and the disclosures and decide if you are comfortable with the process.  It is a matter of doing your research on your Builder and their processes.  After all, this is one of the most important purchases of your life, it is important that you understand and are happy with your final decision.