Building your home? Here’s how a construction loan works

If you’re building your home or doing major renovations, you may be interested in getting a construction loan. Here’s a general overview of how they work and what to look for.

What is a construction home loan?

A construction home loan is a type of home loan designed for people who are building a home or doing major renovations, as opposed to buying an established property. It has a different loan structure to home loans designed for people buying an existing home.

A construction loan most commonly has a progressive drawdown. That is, you receive instalments of the loan amount at various stages of construction, rather than receiving it all at once at the start. You generally only pay interest on the amount that is drawn down, as opposed to on the whole loan amount.

A number of lenders offer construction loans that are interest-only during the construction period and then revert to a standard principal and interest loan.

Of course, a construction loan is just one potential source of funding for your project. The Federal Government’s HomeBuilder scheme, which will give eligible homebuyers and existing owners grants of $25,000 to help them construct or substantially renovate their home. Strict eligibility criteria apply– for example, you’ll need to meet an income test, and be building a new home that’s worth less than $750,000 or a renovation that will cost at least $150,000.

How do progress payments work?

Once a construction loan has been approved and the property is being built, lenders will generally make progress payments throughout the various stages of construction. Progress payments will typically be paid directly to the builder at the completion of each stage.

(1) Slab down or base: This is an amount to help you lay the foundation of your property. It can cover the levelling of the ground, as well as the plumbing and waterproofing of your foundation.

(2) Frame stage: This is an amount to help you build the frame of your property. It can cover partial brickwork, the roofing, trusses and windows.

(3) Lockup: This is an amount to help you put up the external walls, and put in windows and doors (hence the term ‘lockup’, to make sure your house is lockable).

(4) Fitout or fixing: This is an amount to help you install the internal fittings and fixtures of your property. It can cover plasterboards, the part-installation of cupboards and benches, plumbing, electricity and gutters.

(5) Completion: This is an amount for the conclusion of contracted items (such as final payments for builders and equipment), as well as any finishing touches such as plumbing, electricity, and overall cleaning.

As construction loans are progressively drawn down, interest is normally calculated based only on the funds used so far. For example, if by the third progress payment, only $150,000 has been drawn down on a $300,000 loan, interest would only be charged on $150,000.

Construction loan
Source: Monkey Business Images (Shutterstock)

Can you use a ‘standard’ home loan instead of a construction loan?

You may be able to use a standard home loan if you have positive equity (meaning your property is worth more than you owe on it) in an existing standard home loan. You’ll most likely need to have enough equity to be able to borrow the amount that you need without using your to-be-constructed house as security.

Additionally, if you have enough equity in a loan on the block of land itself, or in other assets such as investment properties, then you may be able to borrow the funds for your construction, whether progressively or all at once.

A possible advantage of doing this is that you are able to pay construction costs as and when they fall due, including smaller incidental costs along the way. This may be an advantage for owner-builders or those who are DIYing some portion of the construction.

A potential disadvantage is that by fully drawing the home loan from day one, you are also paying interest on the loan from day one. This could be mitigated by placing any not-yet-spent construction money in a 100% offset account against your loan, although there can sometimes be additional costs associated with this.

You can also consider refinancing a construction loan into a standard home loan once your home is fully built. You may be able to find a lower rate by comparing your options.

How to get a construction loan

Getting approved for a construction loan is a different process to applying for a standard home loan on an existing home.

You’ll typically need to provide the lender with documents including council plans and permits, a copy of your fixed-price building contract and any applicable insurance (such as public liability insurance and builder’s all risk insurance).  You’ll also be subject to normal lending criteria, so will most likely need to provide details of your income and expenses.

A property appraiser will then typically estimate the expected value of the property when completed. This is because when you apply for a construction loan, the lender may consider the expected value of the property upon completion of construction, as well as the total amount required to borrow in order to pay the builder. The lender will typically also require further valuations and inspections during the project.

If your loan is approved, your lender will give you a loan offer. You will then have to make a deposit, as you would with most other types of home loans. This acts as a security at this stage of construction. A larger deposit can help to convince your lender that you are a less risky borrower. You’ll typically need at least a 5% deposit, keeping in mind that you may have to pay lender’s mortgage insurance if your deposit is less than 20%.

For each stage of the construction process, you’ll usually have to confirm that the work has been done, complete and sign a drawdown request form, and send it to the construction department of your lender. Your lender may also request an invoice from your builder for the cost of the work done.

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Owner builder mortgages

One type of construction loan is an owner builder loan, which is specifically designed for people who intend to build the house themselves without the help of a professional third party builder. In this case, owner builders are also not registered builders.

Many lenders only finance construction of homes that are built by licensed builders. Lenders may be hesitant to accept applications for owner builder loans, as they use the property as security against your mortgage. If you’re building this property yourself, they may consider you to be a higher risk.

Lenders who do give owner builder loans may limit the maximum loan to value-ratio for them. This means you may need to pay a higher deposit than you would for a typical construction loan. An additional interest rate loading or fees may also apply to owner builders.

As you can see, building a home is not without its challenges – financial and otherwise. There are pros and cons to both building a home and buying an existing home. Getting the right loan structure in place, though, can help to smooth the process.

This article was originally published by Mitchell Watson.

Main image source: Halfpoint (Shutterstock)

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