What is a construction loan?

As the name implies, a construction loan is designed for borrowers building a home, rather than buying an existing property. Unlike a regular home loan, a construction or building loan covers expenses incurred as the building process takes shape, which we’ll explain further later. As a consequence, construction loans typically incur interest-only repayments because the asset or ‘principal’ doesn’t exist yet. This also helps keep repayments low while your home is being built.

Are construction loan interest rates higher?

Construction loans tend to have higher interest rates than regular principal & interest (P&I) home loans. This is due to three main factors:

Home loans paying interest-only typically have a higher interest rate because of the higher risk for the lender.

There is also more risk for the lender because the asset doesn’t exist yet, and complications could arise on the way - poor weather, tradie delays, material shortages and more.

It’s tough for a lender to determine your final loan-to-value ratio as the home is built and money dished out in stages as needed, and complications or cost blowouts could reduce the proportion of your deposit compared to the value of the home.

Various fees may also be higher, which is usually indicated in the comparison rate. The valuation fee, for example, might be higher because the valuer has to assess the home’s value at every stage of construction, explained below.

How does a construction loan work?

Construction loans work by following a process known as progressive drawdown. The loan amount is progressively dished out as different stages of the work take place. Construction is typically divided into six stages:

Deposit: Pay the builder to begin construction, which usually requires an upfront deposit.

Slab down: Covers the foundation of your property, the concrete base, levelling the ground, plumbing, and waterproofing foundations.

Frame: This covers the frame of the home, which can include some brickwork, roofing, trusses, and windows.

Lockup: Finish putting up the external walls, fill-in with windows and doors.

Fitout of fixing: This covers the cost of internal items such as fittings and fixtures, plasterboard, part-installation of cupboards, benches, further plumbing, electricity and gutters.

Completion: Towards the end of construction, builders and equipment and other contracted items usually need to be paid for. This part also covers finishing touches such as more electrical outlets, plumbing, additional cleaning, paint and other items.

What about renovations?

Construction loans can be used for renovations, however, they might need to be substantial renovations. This is because lenders' minimum loan sizes are usually around $150,000. This could include things like a complete backyard re-model including pool, deck and other features, or adding another storey to the home or extending with another bedroom. If you are paying off a home loan already, your bank or lender might require you to refinance or turn your mortgage into a construction loan, where they can implement progressive drawdown.

Can you use existing home equity for a construction loan?

Many lenders will allow you to tap into the equity you’ve built in your current home to fund construction in the next home. Equity is basically what you’ve made on the property (loan amount repaid and value gained) minus what you still owe. Many construction loans require a 20% deposit, and many lenders will only let you access equity if it’s at least 20%.

One of the main things to consider when accessing equity is that you are eating into your buffer if things go wrong, such as a property market downturn. Another factor is that you’re now paying two mortgages, which can make up a significant chunk of your household budget.

What about land equity?

In Australia land tends to appreciate quickly, while buildings depreciate. Much of your equity in your property is probably in the land, so it stands to reason if you have a vacant block of land you can use the equity in that, too.

If you’ve held onto a vacant block of land for a few years, you’ve probably built up enough equity to now finance a home construction on it. This might seem like a no-brainer, however, a vacant land loan is different to a construction loan, so you will likely need to refinance it. Many lenders will allow this, but double-check to make sure.

What happens when the construction is over?

Construction loans are usually delivered interest-only, meaning the repayments are lower during the construction phase. Once construction ends, the home loan might roll over into a regular mortgage with P&I payments. This means you will pay down the principal of the loan, which will see your regular repayment amount increase significantly. This change can be quite pronounced.

If the total home loan including construction is 30 years, and if your build took two years, your principal repayments would be condensed into 28 years. This makes them higher-looking than if you just bought an established property. However, hopefully the construction works out to be more cost-effective than buying established.

How do you apply for a construction loan?

Applying for a construction loan involves a few extra steps compared to a regular home loan. As you’re building, the council probably wants to know about it. Along with getting a construction loan itself, you’ll need to apply and get approved for:

  • Council plans and permits
  • Professional building plans
  • Proof of land purchase
  • A contract with a licenced builder
  • Proof of builders insurance

After these are acquired, the lender’s valuer will proceed with their valuation. Beyond that, the usual manner of checks and balances apply:

  1. Good savings behaviour
  2. A good credit rating
  3. Have an adequate deposit
  4. Proof of employment and how you’ll repay the loan

Pros and cons of construction loans

There are a few things to weigh up when it comes to building a home versus buying an existing one, not least of which are the considerations that come with taking out a construction loan.

Pros
1. Reduced repayments: Lenders dish out money for each step, meaning you only pay interest on those amounts. The whole construction process is also usually interest-only, making repayments more manageable in the early stages than P&I repayment types.

2. Protection at each stage: Construction loans are usually broken up into six stages, with the lender and valuer assessing work at each stage. This provides some protection from dodgy tradies if say the slab is poured poorly - because there are more eagle eyes watching the work than just you.

3. Cheaper stamp duty and more grants available: Stamp duty is usually only paid on the land, not the home being built. In addition, many state governments offer additional concessions and grants if you’re building rather than buying an existing home.

Cons
1. Risks: There are a lot of unknowns that can happen when building a home - ever watched an episode of Grand Designs? Poor weather, dodgy tradies, and material shortages can all draw out the process and add to costs. Budgets can easily be blown out, and the final product might not be the one you had in your dreams when you started.

2. Higher rates and LVR: Interest rates are typically higher on construction loans because they: are interest-only, delivered in stages, and the lender assumes more risk. If costs blow out, that can also make your LVR higher i.e. reduce the proportion of your deposit.

3. Higher ultimate interest paid: If you pay IO for two years of the construction phase, and the loan then rolls over into a P&I loan, the interest paid will ultimately be greater. You’ll also face higher repayments because the principal repayment is condensed into say, 28 years, not 30 years like with a regular home loan.

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