How do Construction Loans work?

Construction Loan

Many Australians dream of designing and building their own home with all the bells and whistles that would suit their personality and lifestyle. But building a house is no simple task. With multiple parties involved including builders, contractors, lenders and solicitors, the whole lending process can get very confusing.

Construction loans are designed for borrowers wanting to build a brand new home (or investment property). They have a different structure to standard home loans to work alongside construction phases.

 

What’s the biggest difference in loan structure?

Typical home loans use an established house as security against the loan. Settlement occurs and the full loan amount is paid into the borrower’s account at once.

When constructing, the security in question still needs to be built, so the lender gives parts of the loan in progression with construction phases. These are commonly known as draw-downs or progress payments.

There are other differences in a construction loan application, specifically the required documents to get funder approval. Along with standard application and supporting documents, the applicant would be required to supply other documents such as

  • Council approval to build
  • Full signed building contract
  • Complete building plan
  • Contractor quotations

These documents are required by the funder to ensure the borrower has full building approval against respective council regulations, the property plan is within the funder’s standard lending criteria, and estimated costs to complete the build.

The documents are essential to guaranteeing a quick assessment and approval from the funder for finance. 

 

The key phases in construction

The lender will offer portions of the loan at the end of each construction phase to ensure contractors are paid, materials are covered, and to kick off the next phase.

Most lenders require you to exhaust all funds at each stage before continuing.

Building house frame

Phase 1: Slab down or base.

Build from the ground up. The first portion of the loan is paid to cover the foundation of the house and includes levelling the ground, laying concrete or base and plumbing/waterproofing the foundation.

 

Phase 2: House frame.

The second loan portion covers constructing the house frame including windows, trusses and roofing. In most cases this takes around a month to complete.

 

Phase 3: Lock Up.

This phase refers to putting up the external walls, doors and windows to make sure the house can be ‘locked up’.

 

Phase 4: Fitout and fixing.

The loan portion at this stage should cover most of the part that makes home ‘home’. Fitting internal walls, installing the kitchen, cupboards, electricity, flooring and more.

 

Phase 5: Final touches and completion.

Use this portion of the funds to finalise payment of contractors and install final touches.

Clean the site, polish floors and walls, and final inspections to ensure the property is correctly built with no outstanding issues.

 

The loan stays on Interest Only repayments during construction, then typically reverts to Principal and Interest repayments once the house is finished.

Interest during construction is calculated on the amount that is drawn down to date. For instance, let’s say at stage 3 of construction, the borrower has drawn down $200,000 of a $500,000 loan. Interest would be charged only on the $200,000 until the next draw down is made.

 

Do construction loans attract higher interest rates or fees?

It is completely up to the funder on what interest rate they may lend, though additional fees do tend to apply. Typical fees for construction include additional valuation fees during construction – several valuations may be performed to ensure no corners have been cut and the build is continuing on schedule and to plan. This helps reassure the lender that the security will be entirely suitable for the loan.  Other administration fees can apply since the structure of a construction loan is more complex than that of a standard loan on an existing property.

Reduce Home Loans offers construction loans from a low 2.79% p.a. variable (2.82%*(4) p.a. comparison). You can also call us to discuss applying for a construction loan that would best suit you.

 

What if changes are made to the build contract?

If any changes are made after construction starts, the borrower must advise the lender. On a case to case basis, the lender may require reassessment of the entire loan, which can potentially add months to the approval process and construction time. 

It is strongly recommended to have all items finalised prior to getting approval from the lender to avoid timely holdups.

 

Is it the same for owner-builders?

The lending road is a bit bumpier for borrowers who wish to build without the assistance of a professional builder. Many funders are reluctant to lend money to owner-builders as they consider such borrowers to be of higher risk.  Additional rate loadings, fees, or loan-to-value ratio restrictions may apply for owner-builders.

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That about covers the basics of construction loans. If you have any questions for your personal situation and building plans, you can contact our friendly Personal Finance Managers on 1300 733 823 in business hours. We’re always happy to help!

Alternatively, submit an enquiry online and our team will get back to you when available.