Construction loans: What are they and how do they work?

Construction plans.
Photo by Sven Mieke.

A construction loan is a type of loan for those who plan to build their own home, rather than purchase an established property. It differs from a traditional mortgage in that it allows you to progressively draw money from the loan throughout the construction process, while only paying interest on the amount you use.

How does it work?

Rather than paying out a lump sum at the outset, your bank will make funds available to you in instalments as your home is being built. These instalments are known as ‘progress payments’ or ‘progressive drawdowns.’

As your builder moves through each stage of construction, they will provide you with an invoice which must be signed and forwarded to your bank or broker. Once processed, the bank will release funds to pay the builder for the work that has been completed.

Throughout this period, interest will only be calculated against the amount of money that has been drawn down so far. So if you’ve drawn $100,000 on a $300,000 loan, interest will only be charged on that $100,000. 

Once construction of your home is complete and the final progress payment has been made, you will switch from making interest only repayments to principal and interest repayments. Your contracted loan term (e.g. 25 years) will also commence at this point.

How can I apply for a construction loan?

Before you can apply for a construction loan, the plans for your new property will need to be approved by your local council (or an authorised agent acting on your council’s behalf). This is usually handled by your builder or architect.

The council permit must then be submitted to your bank, along with a few other documents (detailed below). These include the builder’s contract, building plans, the schedule of finishes and specifications, and all relevant insurance policies.

Just as with a traditional mortgage, your bank will comb through your finances to make sure you can comfortably service a loan. That means your credit score, income, expenses and any other debts you might have will all come under scrutiny.

A property appraiser will then estimate the value of the property - including land - as if the build was complete. This will help your bank determine how much to lend you. Further valuations will likely take place as your home is being built.

Don’t forget to include any quotes for any out of contract items you plan to purchase, such as fencing, bathroom tiles and landscaping, otherwise the appraiser will not include them in the valuation. 

If your application is successful, your bank will then give you a loan offer and hand over any other documents that might be required as part of your loan agreement. 

How often are progress payments made?

The construction process is typically divided into five stages. Upon completion of each, you’ll have to submit all the relevant claims, invoices and receipts to your lender. The five stages are:

1. Slab

Slab: This is the first stage of the construction process. Here, the concrete slab which will make up the foundation of your home is measured and poured. Once the slab has had time to cure, builders will also connect the plumbing and drains. 

Funds required: Approximately 15-20%

2. Frame

With the slab laid, the builder will now focus on erecting the skeleton of your home. This will take approximately one day for an average, single storey property and between two to five days for a two storey property.

Funds required: Approximately 20%

3. Lock-up

The lock-up stage is when the exterior of your home begins to take shape. As you might have guessed from the name, it involves putting up the external walls, doors, roofing, windows and other components that will allow you to ‘lock up’ your property.

Funds required: Approximately 20%

4. Fit out

Now that your house is properly secured, the builder will be able to install the internal fittings and fixtures, such as lights and plumbing. They will also begin work on things like benchtops and cupboards.

Funds required: Approximately 30%

5. Completion 

In the final fix, loose ends on things like plumbing and electricity will be tied up and painting and detailing will be completed. Site clean-up also takes place during this stage, leaving the building and its surroundings looking presentable. 

Funds required: Approximately 10%

What are owner builder construction loans?

If you are capable of building your new home without engaging a licensed builder, you might be able to apply for an owner builder construction loan. Not all lenders offer these, and the ones that do tend to be quite conservative in their dealings.

For example, unless you have a building license, your lender might only offer 60% of the end market value of your home, meaning you’ll need a deposit of 40%. Some lenders will also tack on an additional amount to your construction quote in case of any cost overruns. 

At the end of the day, if you have no experience in the construction industry, it’s probably best to hire a professional and opt for a regular construction loan.

Which documents do I need?

If you’ve chosen a registered builder to complete the construction, you might be asked to provide the following documents:

  • Copy of signed Industry Standard Fixed Price Contract
  • Copy of buildings plans and council permits
  • Copy of the builder’s licence
  • The builder’s bank account details
  • Copies of insurance policies, including Builders All Risk/Public Liability Insurance, Domestic/Home Warranty Insurance, and Public Liability Insurance

If, however, you’ve decided to build your new home yourself, you should have the following documents ready:

  • Copies of building plans and permits
  • Copy of Quantity Surveyor report outlining the expected costs
  • Detailed outline of construction costs
  • Detailed timing schedule
  • Copies of all quotations, invoices and estimates
  • Copy of soil test and Quantity Surveyor’s comments

Construction loans can be complicated, but they might be just what you need to build the home you’ve always wanted to live in. For more information, visit our home loans hub. And if you’re on the market for a home loan, browse the selection below.

Home loan comparisons on Mozo - rates updated daily

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* WARNING: This comparison rate applies only to the example or examples given. Different amounts and terms will result in different comparison rates. Costs such as redraw fees or early repayment fees, and cost savings such as fee waivers, are not included in the comparison rate but may influence the cost of the loan. The comparison rate displayed is for a secured loan with monthly principal and interest repayments for $150,000 over 25 years.

** Initial monthly repayment figures are estimates only, based on the advertised rate, loan amount and term entered. Rates, fees and charges and therefore the total cost of the loan may vary depending on your loan amount, loan term, and credit history. Actual repayments will depend on your individual circumstances and interest rate changes.

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