What is a construction loan?
A construction loan is a specific type of home loan designed to assist the funding of a new home’s construction. When it comes to a standard home loan, they usually only apply to existing properties. Getting a loan for a home that doesn’t exist yet is a bit trickier, so a construction loan works in conjunction with the building process and helps you pay for it.
How does a construction loan work?
Construction loans are specifically tailored to those seeking to build their own home or renovate an existing dwelling. These loans differ from traditional mortgages as instead of receiving your loan all at once, the lender releases the loan in stages and pays the builder directly with progress payments.
With a construction loan you will typically pay interest-only instalments only on the money you use for construction. Construction loans also have interest-only repayment options during the build period, before reverting to a standard principal and interest (P&I) loan post-construction.
Construction loan payment process
Each construction stage is critical to receiving funds for the build. Each stage is assessed by the lender before funds are released for the next stage to proceed. The release of money on your behalf is known as a draw-down on your loan.
Typically, building a house has a number of construction stages including:
- Preparation – includes plans, permits, connection fees, insurance.
- Base – includes concrete slab, footings, pad and base brickwork.
- Frame – the house frame is complete and approved.
- Lock-up – the windows and doors, roofing, exterior and insulation are all done.
- Fixing – kitchen cupboards, appliances, bathroom and toilet are all in. Plumbing and electrics are done. Your home is plastered and painted.
- Completion – fences up. Site tidied. Any builders or tradespeople receive their final payment.
Construction home loan interest rates
Construction loans typically have higher interest rates than standard home loans. These interest rates might be higher than a standard home loan since it’s harder for a lender to value a home that doesn’t yet exist. To compensate for this risk, lenders tend to increase the interest rate.
In addition to the higher interest rate, construction loans can also have higher fees. A common one is a valuation fee, which can be more costly with a building loan since the lender has to do a valuation of your property after each stage of the construction process. There can also be higher administration fees and upfront fees.
Obtaining a construction loan
Receiving approval for a construction loan is more difficult than obtaining a standard home loan, and frequently involves plenty of paperwork. This is because in addition to assessing your suitability as a borrower, the lender also has to look at the risks involved with the dwelling you’re proposing to build. Lenders will typically ask to see:
- Specific written details such as council plans and permits for the construction.
- Your fixed-price contract (if you are working with a builder).
- Your progressive payment schedule (if you plan to do the work yourself).
- Insurance provisions.
- Contingencies if plans fail or run behind schedule.
This is on top of all the paperwork that comes with home loans including proof of identification, income details, existing assets and liabilities and monthly bills and financial commitments. Provided your suite of documentation is in order and subject to you meeting all necessary lending criteria, your loan will be approved.
What if you want to complete your own construction?
If you are looking to complete construction yourself for building work valued at $11,000 or more, you also will need to obtain an owner builder permit.
In Queensland, owner builder permits are issued across the sunshine state by the Queensland Building and Construction Commission (QBCC) and will only be given to an applicant named on the title of the home. The owner builder status will remain on the title of your home for six years.
If you carry out owner builder work without a permit, relevant Government bodies will issue you a fine. Each state or territory tends to be slightly different, so read up on the rules before you hammer the first nail.
Construction loan pros and cons
Due to the make up of construction loans, the loan ensures that builders and contractors are only being paid for completed work, not for work that is yet-to-be completed.
As you are only charged interest on the loan amount used per stage and not the loan principal this can ease cost burdens while constructing the home.
Stamp duty is something that most home buyers have to pay, but with a construction loan, stamp duty is only actually paid on the land, not the home itself. This can make it cheaper than buying an existing house – if you bought a block of land for $250,000 and spent another $300,000 building the house, you’d ‘only’ pay stamp duty on the $250,000 for the initial land purchase.
You get to watch your dream home unfold, before your very eyes.
The amount of paperwork and hurdles you may face can leave you wanting to pull out your hair. Approval for a construction loan requires a significant amount of work beforehand, and (if you're not building the home yourself) a long conversation with your builder.
The deposit needed for construction loans can be significantly higher than a standard mortgage.
The interest rate on construction loans is generally higher than those of regular mortgage loans as the lender assumes more risk.
Not only can it be time-consuming to begin construction thanks to the mountain of paperwork you have to provide, but the draw-down progressive payment style of construction loans means it can take ages to move from one stage to the next since each one typically needs lender approval.