Unpacking Construction Loans

By Gerv Tacadena

Builders examine plans for a home to be built using construction loans

Many Australians dream of buying their first home, but some won't be satisfied with anything less than their dream home, even if it doesn't exist yet.

For the propective home owner who wants to build up their dream property from scratch, there is a specific financial support product out there for you: the construction loan.

What makes a construction loan different from a standard mortgage?

As you might expect, a construction loan is a type of mortgage product that you can use to cover the costs of building your own home. It is usually a short-term loan that is extended over the amount of time you need to complete the construction of the property.

The structure of a construction loan is quite different than the typical mortgage you would use to buy an established property. For one thing, they usually have an interest-only term over the first year (potentially even the first two years) before reverting back to a standard principal and interest loan.

As the actual construction winds up, you will have to pay off the loan by refinancing and availing of an end loan. More often than not, borrowers convert the loan to a standard mortgage (at either a fixed or variable rate) when the house is fully-built.

How a construction loan works

As explained earlier, a construction loan is not given in lump sump but rather paid out in progression. This means that the lender will release a certain amount of money to you or your builder after each stage of construction. These are called draw-downs or progress payments.

Normally, these progress payments cover five separate stages of building a home. A typical breakdown would look something like this:

  • The first loan amount involves establishing the base of the home: the costs of laying down the foundation of the house, levelling the ground, installing plumbing, establishing the base brickwork, and waterproofing the foundation.

  • The second payment will be given after the framing of the house is done. This portion covers the costs of partial brickwork and roofing.

  • You will get the third amount after the lock-up stage, the time when you construct the doors, windows, and external walls, and insulation of the house.

  • The fourth payment comes at the time when you finish the internal fittings and fixtures of your soon-to-be-house. Costs that are covered by this payment include installation of counters, cupboards, gutters, waterworks, electricity, paints, and plaster.

  • The last payment will be for the finishing touches of the house such as fencing, cleaning of the site, and polishing of floors and walls.

Interest is only charged on the amount of the loan actually used for construction to that point in the process. So, if you had made it to the second stage of construction and had drawn down $200,000 of a $400,000 loan total, you would only be charged interest on the $200,000.

Typically Lenders will send someone to check on the construction before releasing the next payment. This works in your favour as this ensures the quality of the built of your future home.

Applying for a construction loan

There is one main issue to keep in mind when applying for a construction loan – Are you building your home yourself, or are you going to have a registered builder in charge? The application requirements for either method differ slightly, while the latter approach can be a safer route to get your loan approved.

If you have an external builder

The application usually starts with you submitting your property plans to a prospective lender. These plans will be analysed by a professional appraiser, who will determine the expected value of the home when it is completed.

The lender takes into consideration the expected value of the property and the total amount needed to pay the builder, if you are going that route.

Just like a normal home loan, you will have to pay a deposit. This is a form of security and protection, with larger deposits often convincing lenders of the borrowers' credibility.

Provided you have an external builder, they will have to submit a set of documents to your lender before the loan gets approved. You will also have to provide your lender with details about your monthly income and expenses, any assets, investments, and bank accounts you have, and other financial liabilities – this is in line with a standard mortgage application.

If you are an owner-builder

When you apply for a construction loan as an owner-builder, your lender will require a specific set of documents from you, including copies of council certified approved plans, permits, licenses for construction works, detailed outlines of full construction costs, timing schedules, invoices, and insurance policies.

Lenders are sometimes reluctant in approving owner-builder mortgages, usually capping the loan-to-value ratio at 60%. In other words, you should be prepared to pay a deposit of at least two-fifths of the total expected value of the home in order to avail yourself of a construction loan

The pros and cons of construction loans

Pros:

One major advantage of taking a construction loan is protection – because of the way these loans are constructed it ensures that the builders and contractors are only being paid for the work that has been done, and not being paid for work yet-to-be completed.

Another benefit of this style of loan is the diminished amount of interest you have to pay, as you are only charged interest on the amount used and not the full approved loan amount.

Lastly, you will be able to enjoy lower repayments as the construction progresses.

Cons:

The amount of paperwork can considered a disadvantage. Approval for a construction loan entails a lot of work, and (if you're not building the home yourself) a long conversation with your builder.

Another potential disadvantage is the deposit needed for this type of loan, which can be significantly higher than a standard mortgage if you are applying as an owner-builder.

Additionally, the interest rate on some construction loans may be at a higher level than those of regular mortgage loans. However, the rate will typically revert to a standard rate once the construction of the property is completed.

Preparing to take on a construction loan

Because you will play an essential part in building your home, it is essential to be organized, especially if you will act as the owner-builder.

Serious risks may arise if you are not careful and organized in your planning, as any kind of delay or setback can cost you serious amounts of money.

If you are working with a builder, make sure to carefully penalty clauses in your contract to protect you in case of emergencies.

The most important aspect of this process is communication. Make it a habit to talk to your builder regularly, as well as your lender.

More Home Loan Guide