How much of the contract sum should you withhold from your contractor until your project is complete?
How do you get the leverage you need to ensure your project is finished per your contract?
In the contract with your contractor, you want to include a pre-determined amount of money to withhold (retainage) from the final payment, and here are the things you need to know to do that successfully…
First, understand what the phases are. Your contract with your contractor will most likely require that you provide the final payment after “substantial completion” once you get your Certificate of Occupancy… less any pre-determined retainage to deal with punch list items. Did that sound like a jumbled foreign language? It won’t shortly… keep reading.
Substantial Completion essentially means that your contractor has, for the most part, completed the job per your contract documents, and you can move back in to your wonderful, new home. After substantial completion, you get your Certificate of Occupancy (“C of O” for those in the know) from your building department. This pretty much means the same thing as substantial completion, but it is a certificate from the building department agreeing that your home is usable and move-in ready less some minor loose ends. The loose ends that still need to be completed are typically noted on a final “punch list.” After substantial completion, you and your architect will walk through your new home and make a list of things that are damaged and/or not complete. This could include a ding in your drywall, touch-up painting, a small piece of missing trim, etc. This does NOT include something that would need to be completed in order to pass one of your inspections like major electrical or plumbing work. If those things weren’t finished, you wouldn’t get your C of O in the first place, so keep in mind that punch list items shouldn’t be big and scary things. Once everything on the punch list is fixed, you and your architect do a final walk-through with the contractor to ensure everything is satisfactory. THEN you make your final-final (or your second-final) punch list payment.
Your main leverage comes from withholding that first-final payment until you get your C of O. This is like paying for a meal at a restaurant, while the second-final punch list payment is more like tipping the waiter after dinner. The waiter knows he or she hasn’t been tipped yet, so they still refill your water fifty times in anticipation of that payment. However, you cannot release that C of O payment until after you’ve negotiated what is on the punch list and how much that will cost. You then withhold the money needed to complete the punch list from that C of O payment. So, you essentially retain part of your retainage to make your punch list payment later once everything is truly 100% complete. The typical amount you should withhold for punch list items should equal about twice the amount it costs to fix the punch list items. This is industry standard, so don’t shy away from insisting this be part of your contract. I’ve seen clients include language in their contracts in the amount of 5 times the cost of the punch list items. This gives you the ability to withhold enough to hire someone else to do the job in the rare instance your contractor can’t successfully complete the task. Just remember to include your agreed-upon amounts in your contract before the project starts.
The amount of retainage you withhold until you get your C of O can vary depending on the project size. You might withhold 10% on smaller jobs and 5% on larger jobs. 10% of a $100,000 budget might be enough money give you peace of mind, whereas 5% of $100,000 might not. You will need to determine what makes you comfortable and feel like you have a decent amount of leverage. Ask your architect to weigh in on this if you are unsure what to include. Once that number is determined, you reduce EACH payment to your contractor by a percentage of the predetermined retainage. Meaning, if your contractor bills you once a month, and you are expecting the project to take 5 months, then you have a total of 5 payments to make. Each payment would be reduced by 1/5th of the predetermined retainage.
Let’s say you have a $300,000 job and agree to withhold 7% until C of O. You are retaining a total of $21,000. If the project is expected to take 5 months (billed monthly in this example), then you reduce each monthly invoice from the contractor by $4,200 (1/5th of $21,000k). If it is determined that your punch list items will cost $3000 to fix, then you withhold $6,000 from the final $21,000 C of O payment. Your C of O payment will be $15,000 and your punch list payment will be $6,000. If you decide to make a change and say, add a 3rd story, then your budget will go up. Your retainage should go up with it, and your contract re-negotiated.
A word to the wise: Include your architect in each phase of the negotiations, including what should be in your contract with your contractor, what to include on your punch list, how much that might cost, and the final walk through. It is also very common for architects to review/approve each invoice from the contractor before they are paid by the owner. We have experience, and we are your advocate. Take advantage of that. For more super useful information on how to protect yourself from crappy contractors, please see my blog titled How to Protect Yourself From Crappy Contractors.