Building your dream home, like any construction process, requires substantial financial resources. That's where construction loans come into play.
In this guide we will cover a comprehensive overview of construction loans, explaining the application process, loan approval, progress payments, interest payments, and the conversion to a mortgage.
By gaining insights into construction financing, you'll be better equipped to embark on your construction journey with confidence and the ability to stick to your budget.
What is a construction loan?
A construction loan is a specialised type of financial product or loan, which allows the borrower to draw down on the loan in stages so that they can fund a new house build or significant renovation project.
Unlike a more standard loan or mortgage, the funds are disbursed at key milestone stages of construction. Crucially, the borrower only pays interest on the part of the loan that they have already drawn down, not the total loan that has been agreed upon.
How do home construction loans work?
A construction loan works in stages, which is just one of the reasons it’s attractive for a building project. Although different financial institutions may vary slightly, usually the construction loan works as follows:
1. Your licensed builder begins construction in stages
In order to qualify for a construction loan, your home must be built under a fixed-price building contract and signed by a licensed builder. There are usually five key stages of construction: slab, frame, lock-up, fixing and completion.
Within these five broader stages, the following key milestones form payment stages:
- Preliminary works contract issued
- Signing of the contract
- Balance of the deposit to be paid
- Slab laid
- Brickwork 1st plate height - when the full height at which the brickwork of the first floor stops is reached
- Suspended slab laid - slabs that form roofs or floors above ground level
- Brickwork second plate height
- Roof cover upper floor
- Roof cover ground floor
- Lock up - this means the building is ready for internal work, like plumbing and electrical.
- Wet ceramic tiling complete
- Practical completion
Your builder will invoice you at each of these stages of the construction process.
Once the bank or financial institution that has given you the construction loan sees the invoice, they will pay your builder.
2. You’ll then make interest-only repayments
Another feature of a construction loan is that you’re only paying interest on the loan until your construction is finished.
With construction costs an expensive endeavour, interest-only repayments can make a huge difference to your build, particularly if you are also paying rent or a mortgage on another home during the building process.
The interest rates for construction loans can be either variable or fixed, depending on the loan terms. Most construction loans are variable and can only be fixed once the property has been completed.
It is important to carefully budget for interest payments to manage cash flow effectively during the construction process.
3. Once your home is completed and final payments are made
When your beautiful new home is completed and you have made your final progress payment, your construction loan is often converted into a traditional mortgage.
Depending on the bank or financial institution that has lent you the money, you can then start making repayments on the principal or total loan amount, or you may be able to continue paying interest for three to five years before converting to a standard home loan.
Converting a construction loan into a mortgage
Many construction loans are designed to automatically convert into a mortgage once your construction is complete. If your construction loan is not set up this way, you will need to apply for a separate permanent mortgage once construction is complete.
In this process, the lender will undertake a valuation of your home to determine how much it’s worth. You will then have to complete a new mortgage application with various financial checks, like income verification, proof of employment and credit reports before you are given loan approval.
How much deposit do I need for a construction loan?
The deposit you’ll need for a construction loan is similar to the amount you would need to take out a mortgage for an existing home. It typically ranges from 5% to 20% of the total loan amount. The higher your deposit, the more favourable the terms of your loan are likely to be. If you have a smaller deposit, you might find yourself paying higher interest rates.
Can I use the land as equity?
Yes, you can use land that you already own as equity for a construction loan. Having already invested in the land to build the home of your dreams, your lender can see how invested you are.
Depending on when you bought the land, its value might have increased, which might then increase your borrowing power and give you access to better interest rates.
Do I pay LMI on a construction loan?
Whether you pay Lenders Mortgage Insurance (LMI) will depend on the loan to value (LVR) ratio of your loan. If you have paid a 20% deposit or higher, or the value of the land you own exceeds 20% of the construction loan, then you will be exempt from paying LMI. If your LVR rate is above 80%, the lender’s risk is greater, which means you will likely have to pay LMI.
Can I get a construction loan for an investment property?
The short answer is yes. As with building a home of your own, getting a construction loan to finance an investment property will depend on the land, the construction, and your own financial circumstances.
How do I apply for a construction loan?
Once you’ve found and appointed a registered builder, your prospective bank or lender will ask you for a number of documents related to your construction. These are likely to include council plans and permits, insurance provisions, and a copy of your fixed-price building contract.
They will also conduct an ‘as if complete’ valuation, which estimates the market value of the home and land, once the construction is completed. If your contract meets industry standards and your other documents are in order, your application should proceed just like any other loan applicant, although this will depend on specific circumstances and lending criteria.
If you’d like any further information about construction loans or taking the next step in your building journey, please contact us and a member of our team will be happy to help.