I've written about this before, but there are two basic types of homebuilding contracts: cost plus and fixed price. I'm going to address a key exception in the fixed-price contract that you need to be aware of and understand before you sign it.
In a fixed-price contract, your builder promises to build a house that conforms to the plans and specifications in exchange for a fixed price. That means you get what the documents say you get, and the price won't change even if the builder's costs change. If he estimates low on an item, he eats the difference. If he estimates high, he keeps the difference.
There is one exception, and while there's no way around it in some cases, it should be pretty limited in the fixed-price contract. The exception: allowances. So what's an allowance?
Let's say you know you want to install landscaping around your new home when it's finished, but you want to create the landscape plan and specify the types of plants once you can see the finished house. Sounds reasonable.
But, if you're entering a fixed-price contract with your builder, how do you put a price on something that isn't defined yet? You create an allowance. You work together to come up with a budget that makes sense, and you make it a line item in the specifications that go with the contract. It will say something like, "Landscape Allowance: $3,000." That simply means you have a $3,000 allowance for landscaping, and if you go over that, you pay the difference. If you stay under, you get the difference back, or reduce the total contract price by that amount.
How is that different from every other line item in your specifications? What if the builder specified a particular make and model oven and assigned a price to it? In that case, the builder is agreeing to supply that make and model oven for that price. You have the choice to opt for a different oven and alter the price of the house up or down by the difference, or to have the builder install the specified oven.
If the builder ends up paying his supplier more than anticipated for the oven, that's his problem. If he ends up paying less, that's his benefit. That's the give-and-take of a fixed-price contract—the builder owns the risk of prices going up, and you get the peace of mind knowing your price won't change.
The biggest risk with allowances in a fixed-price contract is that they can take over. If you find yourself with lots and lots of items that are "allowances" in a fixed-price contract, then maybe it isn't really a fixed price. There's more homework to do to define what exactly is going into your new home.
Lots of allowances in a fixed-price contract are a crutch. It's easy for a lazy builder to load it up with allowances, get your signature, and then start building without doing the necessary homework up front.
The problem comes when allowance after allowance turns out to be too little for the associated item, and you end up way over budget. For example, you have a $7,000 allowance for cabinets, but when it comes time for cabinets, it conservatively takes $9,500 to build the cabinets for your home. You're now $2,500 over budget, and the house is about half done. If that happens with flooring, appliances, light fixtures, and landscaping, you might be in trouble.
Going over budget shouldn't happen in a fixed-price contract. That's a privilege reserved for the cost-plus crowd.