How do construction loans work?
Building your dream home is different to buying an established home and the finance is different too. Instead of a regular home loan, you use a construction loan.
Everyone has heard of a home loan, but when you’re building a home or making renovations, you may need something more specialised. This is where construction loans come in. Unlike a typical mortgage, construction loans cover building expenses you incur as they happen, throughout specific construction stages.
How does a construction loan work?
Construction loans function differently when it comes to the release of funds and loan repayments. In this type of loan, the funds are released in phases following the stages of construction and not all at once, like in a typical home loan.
For repayments, construction loans are typically interest-only throughout the building process. The interest-only period ensures your repayments are kept at a minimum during construction before reverting to a standard mortgage post-completion.
As soon as your construction loan application gets the tick of approval, the lender will make payments to your builder during each stage of building your house. The builder will outline the amount needed to construct your home, dividing the expected costs into segments.
What does a construction loan cover?
The construction loan covers the labour, materials, contractor or builder fees, and other construction-related expenses. Typically, building a house has several stages, including:
| Stage | What it includes |
|---|---|
| Deposit | Pay the builder to begin construction. |
| Slab down or base | Covers the foundation of your property: levelling the ground, plumbing and waterproofing the foundation. |
| Frame | Build the frame of your property. This often covers partial brickwork, roofing, trusses and windows. |
| Lockup | Put up the external walls and put in windows and doors. |
| Fitout or fixing | This often covers the cost of internal fittings and fixtures, like plasterboards, part-installation of cupboards and benches, plumbing, electricity and gutters. |
| Completion | Covers the conclusion of contracted items (like builders and equipment) and any finishing touches like electricity, plumbing and overall cleaning. |
This method is known as 'progressive drawdown' or progress payments. However, you still need to come up with a deposit yourself.
How are funds released per construction stage?
Lenders will send a valuer to check that the work has been completed at each stage of the construction process before releasing the next payment. This ensures that builders and contractors are only being paid for completed work, not for work that is yet to be completed.
Funds from your approved loan amount are only charged interest as they are paid to the builder (as they are drawn down). If one stage costs $50,000, you'll only be charged interest on that $50,000 for the duration of that stage. But if you draw down an extra $50,000 to pay the builder for the next stage, your repayment will now be based on the interest on that $100,000.
Benefits of construction loans
A construction loan has a progressive payment method that can help borrowers manage their repayments more easily and save on interest over the life of the loan. Because funds are released in phases following the construction progress, the interest you incur on the amount released is not the entirety of the principal loan.
A construction loan can be used for big structural renovations, too, like extending the house or adding on a deck, but not for smaller cosmetic renovations like updating the kitchen and bathrooms.
Construction loans can be a more appropriate loan to take out when building a house from scratch or when looking to complete a major renovation, as you may not get approved for a standard home loan otherwise.
Risks of construction loans
Construction loans aren't without disadvantages. They tend to have higher interest rates than standard home loans, as it's harder for a lender to value a home that doesn't exist yet. The same applies to fees, especially valuation fees.
Constructing a property, in general, can be risky, as there's no guarantee of whether the build will be completed on time or whether it will go over budget. In addition, you will have to factor in additional funds for finishing touches on your new home, as well as rent if you need to live elsewhere during the construction period.
The amount of paperwork and hurdles you may face is significant compared to traditional home loans. Approval for a construction loan requires a significant amount of work beforehand, and (if you're not building the home yourself) a long conversation with your builder.
Can you use your home equity to service a construction loan?
One way to help fund your construction loan is to use any equity you have in an existing property. Equity is a powerful tool for homeowners to use, and as long as you have enough equity to meet the loan's deposit requirements, which will often be at least 20%, but sometimes more, you are able to obtain a construction loan.
Can you use the equity in your land?
You can still technically use the equity you have in a vacant piece of land to fund a construction loan, as land can still increase in value just as a home can. Whether you can use it to build on the same property will be a matter for your lender to discuss with you.
If you're planning on just buying vacant land, a vacant land loan is a separate product from a construction loan. With construction loans, you'll have a set time frame to construct a home on the land.
How to obtain a construction loan
The process of applying for a construction loan differs from applying for a regular home loan on an existing property. In addition to all the usual documents needed for a home loan application, you generally need to provide the following when applying for a construction loan:
- Council plans and permits
- Professional building plans
- Proof of land purchase (or intent if buying land/build package)
- Proof of contract with a licensed builder
- Proof of builder's insurance
If you need additional work for things like a swimming pool, sheds, etc, you will need to provide quotes for the completion of this work to the lender. Your builder should be able to help you collate these documents to provide with your home loan application.
Qualifying for a construction loan
To qualify for a construction loan, the lender may send someone out to the site you intend to build upon to provide a valuation of the to-be-completed home. Once the lender has received this valuation, they may give you the authority to proceed by approving you for a construction loan.
After this, the normal qualifying process for a home loan follows, and you'll need to make a deposit on the property as you would with a standard home loan. To satisfy these requirements, you'll need:
- To demonstrate good savings behaviour
- To possess a good credit rating
- To meet the lender's deposit requirements
- To provide proof that you can repay the loan over time via payslips, bank account balances and transaction history.
It's important to note that when you apply for a construction loan, the building contract is final and has all the required details, including the construction stages, progressive payment schedule and other associated building costs. Even small changes may require the lender to reassess your construction loan application.
Our construction loan approval process
1. Application
Lodge an application online at loans.com.au or arrange a call with a lending specialist through our online booking form.
2. Talk with a Lender
Talk with one of our lending managers. They will help you choose the most appropriate loan for your needs, determine what size of loan you could afford to service, and arrange a conditional approval. If you haven’t filled out an application yet, our lender will fill it out while talking with you and submit it on your behalf.
3. Upload Documents
Using our online portal and mobile app onTrack, you can upload your supporting loan documents. onTrack lets you complete your home loan application entirely on your mobile device from initial contact through to settlement.
Documents you will need include:
- Two pay slips
- Three months of bank account statements
- Evidence that you have sufficient deposit
- Contract of sale for the land or proof that you own it
- Fixed price building contract from a licensed builder
We will then contact your builder and arrange for a property valuation.
4. Final Approval
At this stage, you will receive notifications through onTrack detailing:
- Final approval of your loan
- Mortgage documents and loan agreement pack
5. Land Settlement
If you don’t already own the land, we will fund its acquisition from the vendor.
6. Fund Construction
Now we start to pay for each construction stage as it is completed. As each stage is finalised, we arrange a progressive inspection and then, if everything is in order, we pay the builder directly in accordance with the progressive drawdown stages outlined above.
7. Move in
When the home is completed, you will receive an Occupancy Permit from the local council to say that you are allowed to live in it. Congratulations! You now own a completed home! It is time to collect the keys and move in or find a tenant if it is an investment property.
8. Maintain your loan
Once your home is complete and the final payment is made, your home loan will revert to a standard variable loan. You may order a Visa debit card to have one linked to your offset sub-account.
Construction loans offered by loans.com.au are perfect if you plan to buy land and construct a home, or if you're completing extensive renovations to your existing property. To find out more, get in touch with one of our home loan specialists.
Find out in under 2 minutes if you qualify for one of our low rate home loans.
About the article
As Australia's leading online lender, loans.com.au has been helping people into their dream homes and cars for more than 10 years. Our content is written and reviewed by experienced financial experts. The information we provide is general in nature and does not take into account your personal objectives or needs. If you'd like to chat to one of our lending specialists about a home or car loan, contact us on Live Chat or by calling 13 10 90.
