How do construction loans work?

How do construction loans work?
A construction loan is a type of home loan that's designed for people who are building their own home as opposed to buying an established one.
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A construction loan is a type of home loan that's designed for people who are building their own home as opposed to buying one.

Unlike a regular home loan, a construction or building loan covers the expenses you incur as they happen throughout the stages of construction.
Construction loans have a completely different structure to a traditional mortgage. A construction loan divides your loan into stages based on what part of the building process you're in.
This method is known as 'progressive drawdown' or progress payments. However, you still need to come up with a deposit yourself.

Construction loans can be a more appropriate loan to take out when building a house from scratch or when doing a major renovation, and you might not get approved for a standard home loan otherwise.

How does a construction loan work?

Construction loans function very differently from a standard home loan. They typically charge interest-only repayments during the building process.

The interest-only period ensures your repayments are kept at a minimum during construction before reverting to a standard principal and interest mortgage after construction.

Once your construction loan gets the tick of approval, the lender can then 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. 
Varying between lenders, the progressive drawdown process will usually look a little something like this:
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. 

Lenders will send a valuer to check the work has been completed at each stage of the construction process before releasing the next payment. 

Funds from your approved loan amount are only charged interest as they are paid to the builder (as they are drawn down). So 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.

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).

Risks of construction loans 

Construction loans aren't without disadvantages or risk. 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. The final value of the house can also differ from what you initially expected.

The right construction loan can help minimise these potential risks, however.

Can you use the equity in your home for a construction loan?

Yes, one way to 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 can get a construction loan this way. 

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 timeframe to construct a home on the land.

How to get a construction loan

Applying for a construction loan is a bit different to applying for a regular home loan on an existing property. In addition to all the usual documents needed for a home loan application, you may need to provide the following when applying for a construction loan:

  • Council plans and permits
  • Professional building plans
  • Proof of land purchase
  • A 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 these to the lender.

How do you qualify for a construction loan? 

The lender may then send someone out to give a valuation of the to-be-completed home. Once the lender has received this valuation, they may give you 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. This means you'll still need:

  • To demonstrate good savings behaviour 
  • A good credit rating
  • To meet the lender's deposit requirements 
  • And prove you can repay the loan over time 

It's important that when you apply for a construction loan that the building contract is final and has all the required details including the construction stages, progress payment schedule and other building costs. Even small changes may require the lender to reassess your application. 

loans.com.au's construction loan is perfect if you plan to buy land and construct a home or if you're completing extensive renovations to your existing property. Our construction loan offers a competitive interest rate that converts to our market-leading Offset variable home loan once the construction of your new home is complete.

To find out more, get in touch with one of our home loan specialists.

Tags: building a home | construction loan

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