Things to know before renovating and extending your house
Considering renovating your home? Weigh up the costs, benefits and risks before you start....
23 Feb, 2024
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Principal & Interest
Principal & Interest
Principal & Interest
Principal & Interest
Principal & Interest
Principal & Interest
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.
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.
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.
Once your construction loan gets the approval, your lender will be able to make payments to your builder during every stage of construction. As each phase is completed, your lender will require you to present an invoice from your builder before it can issue a payment.
Your builder will outline the total amount needed to construct your home, dividing the expected costs into several segments. Lenders will be very involved in the process — they will typically send someone to check on the progress of construction before releasing the next payment to your builder. This move is to your advantage since it ensures the quality of your future dwelling.
The first loan amount will cover the costs of building the base of your home. This stage includes laying the foundation of the house, levelling the ground, installing plumbing, and waterproofing the foundation. This stage comprises 10% of your contract and takes up to two weeks.
For the second stage, your lender will pay for the expenses incurred building the frame of your property. During this phase, your builder will focus on constructing the trusses, roofing, and windows of your home. Taking up 15% of your total contract, this stage may also include some of the brickworks needed. This stage of construction takes up a month to complete.
This period gets the most significant proportion of your contract at 35%. It is called lock-up since all its elements are for the purposes of closing up the property. The third chunk of payments from your lender will be for the construction of external walls, doors, and insulation of the house. Builders need four weeks to finish this stage of construction.
In this stage, your lender will be paying for all the fixtures and fittings needed to complete the home — shelving, kitchen and bathroom cabinets, doors, tiles, and all internal claddings will be constructed. Plumbing and electrical systems will also be finalized. This stage makes up 20% of your total building contract. Fixing or fit-out stage usually takes up to six weeks of work.
As the name implies, this stage covers all the finishing touches, including painting, installation of fences, polishing of walls and floors, and cleaning of the site. These concluding activities take up 15% of your total contract. This final stage takes up to two months.
After the construction of the house, you have to do final rounds of inspections to make sure that the property is built correctly. You have to make sure that within three to six months after the property construction is complete, you inform your builder of all the issues and additional works that need to be done.
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.
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.
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.
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:
After these are acquired, the lender’s valuer will proceed with their valuation. Beyond that, the usual manner of checks and balances apply:
In addition to the usual requirements for taking out a loan, you will need to provide certain documents to qualify for a construction loan.
This is the most important document you have to provide since this outlines the construction stages, progress payment schedule, the timeline of works, and the costs of building the home.
This is the blueprint of your future home. It includes the layout and the size of the house you intend to build.
Aside from the plan, you will need to provide your lender with the building specifications, which will detail the materials and finishes you are planning to use for the construction of your house.
Your lender will also need the estimated costs of building additional features in your property such as solar panel installation, pools, and landscaping. Lenders often look at these things and assess if these will be able to boost the value of your home.
When you get a construction home loan, your lender will only charge interest on the amount of the credit that was drawn at a particular stage of construction. For instance, even if you get an approval for a $300,000 construction loan and have only used $100,000 so far, interest will only be charged on the $100,000 you’ve used.
Throughout construction, the loan remains interest-only. At the end of the development of the house, you may ask your lender if you can continue with an interest-only scheme. You can also change your loan to principal and interest.
Some homeowners choose to either refinance their construction loan after the process is finished or use an end loan. Others convert the loan to a standard mortgage when the house is fully constructed.
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.
Construction loans does not work the same way as a regular home loan. A construction home loan covers the expenses you incur as you build your own home.
Construction loans have an entirely different structure than the typical housing loan. If you use a construction loan, the amount you estimate your home might be will not be given away in lump sum — instead, your lender will be giving you portions of your loan in progression, or what are widely-known as draw-downs or progress payments.
However, you need to come up with a deposit that will cover the initial cost of the materials needed to start construction. Typically, the amount of down payment your lender will require is 5% of the total building cost.
Find answers to frequently asked questions about construction home loans. Yourmortgage.com.au helps property owners to increase their insights on loans for construction purposes.
When entering a construction contract, you and the builder must negotiate whether to have a fixed-price or a cost-plus arrangement.
A fixed-price contract is better for those with tight budgets, as it states the cap on the budget for the construction.
A cost-plus contract, on the other hand, may be better for those who want the highest quality materials for the construction of their home. This, however, could be prone to disputes over price calculations.
Structural renovations involve significant changes to your home, including tearing down walls, creating new rooms, adding a level, or constructing an extension.
On the other hand, non-structural renovations typically include cosmetic changes to your house, like laying floorboards, repainting your walls, changing the furniture, and other similar upgrades.
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.
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.
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