If you asked most people what’s the most stressful part of building a home, most would say finances. However, understanding the basics of financial terms will help you navigate money issues and make the best decisions for your situation.
A building contract is a crucial part of any home building project. It outlines important details including what the contractor has agreed to perform for what price. It provides protection and evidence for both parties should anything go wrong down the track. Another important detail is payment terms including how money payments will be made and how the final price will be decided.
The two main contract types of contract are lump sum and cost plus. Let’s dive into the difference between the two and the pros and cons of each so you can make an informed decision.
Table of Contents
Step 1. Understanding The Different Contract Types
Lump Sum Contract
In a lump sum contract (sometimes called a fixed-price contract), the final price is predetermined at the time of signing the contract. Basically, your contractor or builder agrees to complete the project scope of work for an agreed-upon price. This price will be the builder’s budget for materials, labour, and eventual profit.
When drawing up the contract terms for a lump sum contract, it’s more essential than ever to make clear the scope of work covered by the agreed-upon price. Secondly, it’s important you are crystal clear on what you’re getting for your money. This will help you avoid any nasty surprises down the track, and factor in any extra costs that are outside the contract.
Advantages of Lump Sum Contracts
Simplicity: A lump sum contract is much more straightforward thanks to a price being agreed upon from the outset.
Financing: Due to the more straightforward nature of lump sum contracts, it’s often easier to get a loan.
Less chance of price blow-out: An initial fixed cost provides a solid agreed-upon price and the builder will suffer the consequences of going over budget.
Disadvantages of Lump Sum Contracts
Risk of inferior work: The trouble of having a set budget is contractors may be tempted to cut corners by buying cheaper materials and rushing labour. Good builders will set a price that works for them and therefore, shouldn’t have this issue.
Can be difficult to estimate: It’s best to factor in the chance there will be additional costs at some point during the build.
Cost Plus Contract
A cost-plus contract is more complex than a lump sum contract but can have potential benefits when done well. Basically, rather than paying one agreed-upon price, the homeowner will pay the expenses for construction, building materials and extra costs themselves. Contractors like these contract types because it ensures that they’re paid for direct and indirect work performed and any extra costs. Homeowners may like this because they can have more control over spending and their budget.
A cost-plus contract offers more control and flexibility, but remember this can be a double-edged sword. When it goes well, you’ll get exactly what you want and your money will be better spent. When it doesn’t, things can quickly fall apart and the whole process can be overwhelming.
Advantages of Cost-Plus Contracts
Can incentivise builders: Because there isn’t a set amount of money, builders are less likely to purchase cheaper materials to increase their profit margin.
A cap can be put on the project: Worried a builder may go wild and spend your money recklessly? It’s common to add a cap on how much can be spent on the project to avoid this very scenario.
Offers more flexibility: Because the amount of money being spent is more flexible, you can alter your budget to acquire certain materials.
Disadvantages of Cost-Plus Contracts
Can cause issues with cost records: It’s essential you trust your builder and they keep records of all their spending. If records aren’t kept well, there can be issues with paying for materials and accounting for all your money.
Issues with contractors: Builders need to be able to purchase materials before invoicing this back to the homeowner. If a building company is in financial trouble, this is going to cause problems.
Prices can spiral: There is the potential for cost plus contracts to have no spending ceiling meaning there’s the financial risk that builders could recklessly spend your money and leave you with the bill.
Step 2: Key Considerations for Choosing a Contract
Budget and Cost Control
A key factor in choosing the right contract types is taking a close look at your own financial situation. While it’s easy to get swept up in the excitement of building your dream house, you need to keep an eye on your finances to ensure you don’t run up a debt that will cripple your prospects in the future.
Though there are many circumstances to consider when drawing up a contract, the following is a general rule of thumb:
- Homeowners with a fixed budget may prefer a fixed-price contract for cost certainty.
- Homeowners with a flexible budget may prefer a cost-plus contract for flexibility.
Risk Tolerance
Risk tolerance refers to the amount of loss you are willing or able to handle when making an investment. This is important to know at it helps you get an understanding of where your safety net is. Those with a higher risk tolerance (who can afford to take a bigger gamble) may be better suited to a cost-plus contract, while those who have a fixed budget will prefer lump-sum contracts.
Step 3: Comparing Contract Types
Lump Sum vs Cost Plus Contracts
When choosing between a lump sum contract and a cost-plus contract, you’ll need to figure out whether certainty or flexibility is your top priority. Lump sum contracts provide cost certainty, while cost-plus contracts offer flexibility. Another way to look at it is lump sum contracts shift the risk of cost overruns to the contractor, while cost-plus contracts shift the risk to the homeowner.
Remember there isn’t a universal answer as to which contract type is best. You’ll need to assess your own situation and budget to figure out what is the best option for you.
Making the decision: Evaluating Your Needs and Priorities
Questions to Ask Your Builder or Contractor
What does your quote cover? Find out whether it includes all actual costs of the construction project including material and labour costs.
How do you communicate spending and provide updates throughout the building process?
What construction contract do you prefer and why?
Can we run through when payments need to be made?
Anything you don’t understand about the contract, ask questions to clear it up. Buildi can help with this if you need assistance.
Budgeting and Financial Planning
Finances are complicated at best of times, especially when it comes to a project as large as building a home. Talk to a financial advisor so you can organise a realistic budget and plan that you can stick to. It’s also a great opportunity to explore your loan options. Having an impartial party look at your finances will help guide you to make objective decisions and keep everything in check.
Legal Considerations
Any building contract, whether it’s lump sum or cost plus, needs to outline the following details:
- The scope of work
- a completion date
- the amount to be paid
- agreements about retention and security
- name of building company or contractor
- license number of the contractor
- address of the construction project
We’ve all signed a contract that we’ve not understood, whether it’s for our new phone or signing up for a streaming account. However, for a house, it’s crucial you understand your contract. Having a third person, like a solicitor, look over a contract is recommended to make sure everything is legit. Hopefully, you’ll just end up with peace of mind, but it could potentially save you from signing something fishy.
Legal Protections and Remedies
A contract helps provide protection should any issues arise, but you also have some other protection to fall back on. Home Warranties and guarantees are both designed to protect you and your builder
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