What is a Construction Loan?
Construction loans work differently from regular home loans. Instead of being paid in full on settlement, a construction loan is paid out in stages known as progress payments. Your loan isn’t fully paid out until construction is complete.
The payment structure is designed to give the borrower some financial relief from repayments, since you aren’t able to live in the home until it’s finished. The loan structure also provides you with an extra measure of security if the quality of your new build doesn’t meet expectations.
If your construction loan includes the purchase of the land, a property appraiser will calculate the value of a construction loan based on the value of the land plus the value of the property, based on plans and specifications.
Who is a Construction Loan Good For?
A construction loan is good for people who want to build their own home from the ground up. It can also suit investors who want a new construction. However, it is not usually geared towards people who intend to build a home and immediately turn around to sell.
A construction loan can be a good fit for first time home buyers or existing homeowners; its unique structure means that borrowers don’t pay interest on the full loan until the build is completed. This can make it much easier to manage loan payments in addition to current accommodation costs.
What are Progress Payments?
Progress payments are made by the lender at predetermined project stages, or milestones. Before your loan is approved, a progress payment schedule will be established. The schedule includes a series of construction milestones; as each milestone is achieved, the loan amount for that stage is ‘drawn down.’
For example, if your property’s construction costs were valued at $400,000, those funds will be released in stages to match the project progression, not all at once.
Your lender may have the property valued at each phase to ensure it is up to scratch before paying out the next loan installment. Depending on your loan terms, the funds may be paid directly to the builder, or to you in order to pay the builder. Fees may apply to each progress payment.
Construction Loan Deposits
Just as with a regular home loan, you will need to save up a deposit for a construction loan. Whatever your deposit, it must be paid in advance, usually when you sign your building contract. In many cases, the deposit funds the first stage or two of the construction process. The lender will not make payments until the deposit has been fully paid out.
Also, like regular home loans, loan-to-value ratios (LVR) are likely to apply. If you’re unable to supply a minimum deposit of 20% of the loan’s value, you may be required to purchase lenders mortgage insurance (LMI).
Documents Required for a Construction Loan
Construction loans tend to require more paperwork than an ordinary home loan. You’ll need the regular home loan application documents, like proof of income and assets.
Further application documents may include, but are not limited to:
- Council-approved plans and building specs
- Signed and dated building contract with a reputable, licensed builder
- Progress payment schedule
- Builder’s insurance
Quotes for work not included in the contract (for example, driveways)
Pros and Cons of a Construction Loan
Carefully consider the pros and cons of a construction loan before deciding if it’s the right move for you.
- Pay as you go interest: During construction, only pay interest on the amount you’ve drawn down
- Staged payments: Assess the quality of work as it progresses to avoid paying for poor workmanship
- Save on stamp duty: Only pay stamp duty on the purchase price, not the final value of a construction
- Lower repayments: Interest-only repayments until construction is complete and the loan is fully drawn down
- Customise your home: Design your dream home from scratch
- More upfront paperwork: Provide regular application documents as well as proposed building documents
- Weather delays: Unforeseen weather can prolong construction schedule and inflate the budget
- Over budget: Construction costs may exceed the initial budget
- Change of heart: Variations to the agreed-upon plan can be costly to implement
- Post-construction costs: Some details aren’t covered in the building contract, such as driveways
How to Apply for a Construction Loan
With a cost-plus contract, you’ll be charged for labour and materials. This allows the builder to include a markup for the materials sourced.
Complete the construction loan application with your preferred lender. You’ll likely need to provide the building contract, house plans, and proof of income along with any other requested documents. When the loan is approved and the deposit paid, construction can begin!
Your lender will conduct ongoing inspections as required, including a final property inspection when construction is complete. If you wish to top up your loan to add some finishing touches, this may be allowed after completion.
How to Compare Construction Loans
Shopping around for a construction loan is just as important as it is for a regular home loan. Identify the features you’re looking for, and compare apples to apples. Features vary by lender but may include the following:
- Interest-only payments during construction
- Principal + interest repayments after completion
- Fixed or variable interest rates (note that most construction loans offer variable rates)
- Offset account