How do construction home loans work?

If you’ve found the perfect location, but not the perfect property, building your own dream house could be an option to consider. Financing your build may require a construction loan, which isn’t the same as a typical home loan.

What’s the difference between a construction loan and a home loan? 

In a typical mortgage for an existing property, you borrow the money you need to buy the property from a bank or mortgage lender as one lump sum, to be repaid over a long term (often 20 to 30 years). This loan is secured by the value of the property, so if you default on your repayments, the lender can recover its money by repossessing and selling the home.

However, while it’s relatively simple to find the value of an established property, it’s not so easy for a property that has not been built yet. This could make a bank less eager to provide a large home loan as a lump sum, as there’s a higher risk that the property’s value may not be high enough to secure the loan and reduce their financial risk.

In a construction loan, you borrow money from a lender in stages, drawing down funds as required to pay for the build project as it progresses over a shorter term, such as 12 months. This could allow you to access the money you need to build your property while limiting the lender’s financial risk in case construction is delayed, stalls, or encounters other issues.

Standard home loans often offer a variety of options and choices, such as fixed or variable interest rates, or principal and interest or interest-only repayments. Construction loans are much more likely to be variable rate interest only loans during the construction phase, before reverting to a more typical loan once the project is complete.

How do you apply for a construction loan? 

Much like a regular home loan, you’ll need to fill out a home loan application form to apply for a construction loan, complete with payslips, a list of yearly expenses and personal identification documents. You may want to have a 20 per cent deposit saved up so you have a loan to value ratio (LVR) of 80 per cent, as well as a good credit rating.

You’ll also need a fixed price contract from a builder (including a building plan and a schedule of payments, variations and quotes if applicable) and documents showing you have council approved plans, as well as a quantity surveyor report for building contracts in excess of $1 million.

What is the construction loan process? 

The loan is split into stages or progress payments to coincide with the different stages of construction.

Most have five stages:

1. SLAB: The concrete slab is laid. Approximately 15-20 per cent of funds paid (may include a 5 per cent deposit to the builder)
2. FRAME: Exterior frames are built and brickwork is completed. Electrical, plumbing, gutters and insulation are installed. Approximately 20 per cent of funds paid
3. LOCK-UP: Remaining windows, doors, external walls and roofing are installed so the home can be effectively locked up. Approximately 20 per cent of funds paid
4. FIT-OUT: Internal fittings and fixtures are completed at this stage including lights, powerpoints and other plumbing. Approximately 30 per cent of funds paid
5. COMPLETION: When contracted items are finalised including fencing and site clean-up, final detailing and painting works are carried out. The bank or their valuer will inspect at this stage before making the final progress payment of approximately 10 per cent of funds.

At each of the stages, the builder will issue you an invoice. If you’re happy with the work, you sign it and send it on to your bank or broker to release the funds to the builder.

Do you get a loan for the land and then build the property?

You can buy a house and land package and the first drawdown will be for the land and subsequent progress payments would cover each stage of the construction.

Or you can use a construction loan to build or renovate a home on land you already own.

What happens if unexpected costs happen? 

Construction loans typically require a fixed price contract from a builder before your lender will give the green light.

But the cost difference between a fixed price contract and a cost-plus arrangement can be as much as 20 per cent to allow for any unknowns once the build commences.

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