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A construction deposit is a special bank account with your mortgage where you receive borrowed money for the (re)construction or preservation of your home.
You pay bills from this deposit for things like a contractor or building materials by sending invoices to your lender, who then pays the money out of the deposit or transfers it to you.
You receive interest on the money in the deposit and pay interest on the withdrawn portion, some of which may be tax deductible.
Why is a construction deposit handy?
- Check
For the lender, it is nice to be sure that the money borrowed will actually be spent on the remodeling or new construction and that the value of the collateral (the home) will increase.
So this then lowers the risk for the lender because the mortgage is calculated based on the higher market value after the renovation. The deposit also ensures that there is a clear, controlled use, which prevents misuse and contributes to the increase in value of the home.
- Tax benefit
You can get a mortgage interest deduction on part of the interest you pay. So you can deduct the interest you pay on the construction deposit from your income.
However, with a new construction mortgage, you must deduct the amount you receive in interest on the construction deposit balance from the amount you pay.
- Appraisal value:
A building deposit is good for the appraisal value because it ensures that renovations are financed that increase the home value.
The appraiser bases the final mortgage and the appraisal value on the value after remodeling rather than the current state, allowing you to borrow more for an increase in value.
How does applying for a construction deposit work?
1. Applications:
You apply for the construction deposit as part of your mortgage, such as for a new home construction or the remodeling of an existing home.
Conditions do apply. For example, you must show that you have sufficient income to pay off the loan and the requirement that the renovations will actually add value to the house.
Loose items such as furniture or curtains cannot be paid for with the construction deposit.
2. Money in the account and paying bills
Money from a construction deposit is not deposited directly into your private account, but is used by the lender to pay invoices for your remodel.
This can be transferred by the lender directly to the to the contractor, installer, etc. Or the amount is paid to your own account if you have already advanced the bill yourself.
3. Interest:
With a construction deposit, you simultaneously pay and receive interest on the money not yet spent.
You pay interest on the full amount of the mortgage, including the money in the construction deposit, but you receive interest on the money not yet withdrawn. Often this is an equal percentage as your mortgage interest rate, so you pay net interest only on the portion of the mortgage you actually spent.
As you withdraw more money from the deposit, the amount in the deposit becomes smaller, so you receive less and less interest and your monthly expenses will increase.
4. Period:
The validity of a construction deposit varies by bank, but is usually 2 years for new construction and 1.5 years for existing construction. In most cases, you can extend the term once for a pre-agreed period, such as 6 months.
The exact term and extension options are described in your lender’s terms and conditions.
5. Remainder:
At the end of the construction deposit, the remaining amount smaller than a certain amount (depending on your bank) is deposited into your checking account. A large remaining amount is used to pay off your mortgage.
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