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Calculating The Interest On Your Progress-Payment Construction

Calculating the amount of interest expected in a progress-payment contract on a newly built house can sometimes seem daunting.  In this article, we walk you through some easy calculations.

Recently we discussed the difference between Turn-Key construction contracts and Progress-Payment construction contracts.  You don’t need to worry about interest payments for Turn-Key contracts.  They are built into the price, which is why they tend to be more expensive.  The builder has calculated how much interest he or she will pay and added it on to the price of the contract.

But for Progress-Payment contracts, you begin paying money from the minute you settle on the section, and as you continue to draw down money throughout the build project.  So how much should you allow for interest costs for the project?

Progress-Payment Example:

Let’s use an example project to work through some numbers.

Section cost: $300,000
Cost to build: $400,000
Time to build: 8 months

So the section is going to settle, for example, on 1st March and, 8 months later, the house is expected to be built.  How much interest would we expect to pay?

Section cost:

From Day 1, we’re going to be paying interest on the section.  Let’s assume we will pay around 4% interest on $300,000 for 8 months.

Quick tip: once you have purchased the section, you should be able to fix this account at the lower “fixed” rates.

$300,000 * 0.04 (interest) = $12,000 interest in a year
$12,000 /12 (months) = $1,000 per month
$1,000 * 8 months = $8,000

So the section is going to cost us around $8,000 in interest to hold for 8 months.

Build cost:

The builders aren’t going to ask you for a lot of money on Day 1 of the build.  Remember, it’s a Progress-Payment contract so they will only ask you for money once they’ve completed the work.

In the beginning of the project you won’t be paying any interest on the build part but by the end, you’ll have drawn down all the money.  If you average this out, it amounts to you owing half the build cost over the whole project.  What does that mean?

In this instance, you could calculate half the build cost ($400,000 divided by 2 = $200,000) and see how much interest you would pay over that amount for 8 months.

$400,000 (build cost) / 2 = $200,000
$200,000 * 0.05 (interest) = $10,000 interest per year
$10,000 / 12 (months) = $833 interest per month
$833 * 8 (months) = $6,666 interest total for 8 months

Cost overruns:

So, for an 8 month build, we know that:

The section will cost us: $8,000 of interest
The build portion will cost us: $6,666 of interest

The total cost of interest for this project will be approximately $14,666.  Correct?

Actually, not quite.  Construction companies do their best to estimate the time to complete but they have no control over the waiting time at the Council, the weather – particularly if your build is done over the winter – and a lot more.  If the company is saying 8 months, I would add 50% to that (in this case, that would make it 12 months, or a year).

So even though we have calculated the interest cost to be $14,666 we could times this by 1.5.

For this example then, we would budget for the interest cost to be up to $22,000.

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Can I capitalise the interest of a Progress-Payment contract onto the mortgage?

The answer to this depends on the amount of deposit / equity that you have. Generally, if you have more than 20% deposit (or useable equity in your current properties), you will be able to borrow more to cover the interest over the build. First home buyers are often paying rent so additional mortgage payments can be hard. Borrowing the interest costs reduce this cashflow pressure. Let's see how this would look in the example above.

Total cost to purchase a section and build was: $700,000
20% deposit: $140,000
Expected interest costs: $22,000

In this example, if you had $162,000, you could borrow $560,000 (which is 80% of the build) and keep $22k of your savings aside to pay for the interest costs throughout the build.

Summary:

To calculate the interest costs of a Progress-Payment contract, you need to know 3 things:

  • What will the section cost?
  • What will the build portion cost?
  • How many months is the build likely to cost?

From there you calculate:

  • The interest cost on the section
  • The interest cost on half of the build cost (the average of what you will owe)

Total that all up and add some more time (usually another 50% of the build time) on to allow for unforeseen delays with construction.

Need some help with calculating your interest costs?

Our Advisers will work you through the calculations. Give your local Adviser a call/email to help you with the numbers.

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