How do land and construction loans work?

If you decide to buy land on which to construct a new house, there are a few ways you can raise the funds you need. While there’s a chance that a standard home loan may work for you, it’s more likely that you’ll want a special kind of loan for your land and house.

Compare construction loans

It's not always possible to use a standard home loan to buy land and build a house. This is because the value of the property won't be certain until construction is complete, making it unsuitable as security for your loan.

However, if you already own another property, or the land where you plan to build, you may be able to use your equity to apply for a standard home loan to pay for the construction of your new house.

Of course, there are also specialist loans available for borrowers in your situation.

Land loans

Land loans help you to buy land on which you intend to build your house. These are particularly helpful if you wish to acquire the land now and construct your home later. When considering a land loan vs a construction loan, bear in mind that land loans do not specify a time limit within which you need to construct your house.

Construction loans

When you take out a construction loan, the lender approves the amount that your house will cost to build, but you ‘draw down’ the loan in stages. You pay your builder as the construction progresses, and you’ll be charged interest on what you've drawn, not on the entire amount. The bank may require you to complete the construction within a specific period.

The amount you can borrow on a construction loan depends on the bank's estimated ‘on-completion value’ of your future home. The construction cost quoted by the builder is also taken into account when calculating your borrowing limit.

Most construction loans are interest-only, meaning that you pay only interest until your house is completed. After that, you start to repay the principal and interest. Not needing to repay the principal while your home is being built eases your cash flow situation during that period.

While construction is underway, your lender may want to inspect the progress to see that it matches the terms of the building contract.

While both land loans and construction loans help finance property, they serve distinct purposes. A land loan is typically used to purchase a block of land, often for future construction. These loans provide flexibility, as there’s no requirement to build within a specific timeframe.

A construction loan, on the other hand, is designed for constructing a house. These loans are disbursed in stages, with funds released as construction progresses. They are typically interest-only during construction and transition to principal and interest repayments upon completion.

Can you combine land and construction loans?

If you plan to construct right away, you may want a combined house and land loan. This is made up of two components - a land loan and a construction loan.

1. A turnkey package, where the builder takes care of everything related to the land and construction. When the house is completed, you can move right in. The total cost is finalised at the start of the project. You pay a deposit to the builder, usually about 10%. The balance of 90% is released by the bank when your home is completed and a code compliance certificate has been issued.
2. A house and land package, where you buy the land and can get your house built whenever you decide you’re ready. You can usually borrow up to 95% of the value of the land, but your lender may require you to purchase Lenders Mortgage Insurance (LMI) if your deposit is less than 20%. Your borrowings will consist of a land loan and a construction loan.

Whether you’re planning to buy land now and build later or start construction immediately, understanding the options for land and construction loans can help. Each type of loan serves a unique purpose, and comparing them can help you find the best fit for your needs. Take the time to assess your financial situation, borrowing capacity, and timelines before making a decision. You may also consider speaking with a mortgage broker to understand your options better.