How do construction loans work?

What is a construction loan?

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 loan covers the expenses you incur as they happen throughout the building process. Construction loans have a completely different structure to a regular home loan. 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 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.

How does a construction loan work?

Construction loans function very differently from a standard home loan. They typically charge interest-only repayments during the build. This is to make sure your repayments are kept at a minimum during construction before reverting to a principal and interest loan afterwards.

Once your construction loan gets the tick of approval, the lender can then make payments to your builder during each stage of construction. The builder will outline the amount needed to construct your home, dividing the expected costs into segments.

Varying between lenders, the loan 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 Lay down the foundation of your property. This often covers 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 Do the internal fittings and fixtures of your property. This often covers the cost of plasterboards, part-installation of cupboards and benches, plumbing, electricity and gutters.
Completion This is an amount to cover 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 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).

When the construction period ends, the construction loan reverts to a standard home loan.

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

Note that not everything is included in the construction. If you need additional work for things like a swimming pool, sheds, etc you will need to provide quotes for these to the lender.

After the lender has all this information, the lender may send someone out to value the land and 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 process for getting a home loan follows, and you'll need to make a deposit on the property as you would with a standard home loan.

If you're thinking about taking out a construction loan, our construction loan is perfect if you plan to buy land and construct a home or are 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.

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