A construction loan is a type of home loan designed for people who are building a home or doing major renovations, as opposed to buying an established property. It has a different loan structure to the type of home loans used to buy an established property.
A common feature of a construction loan is a progressive drawdown. You receive instalments of the loan amount at various stages of construction rather than receiving it all at once at the start of the loan period.
A number of lenders offer construction loans that are interest-only during the construction period and then revert to a standard principal and interest loan. As construction loans are progressively drawn down, interest is normally calculated based only on the funds used so far. For example, if by the third progress payment only $150,000 has been drawn down on a $300,000 loan, interest would only be charged on $150,000.
How do progress payments work?
Once a construction loan has been approved and the property is being built, lenders will generally make progress payments throughout the various stages of construction. Progress payments will typically be paid directly to the builder at the completion of each stage.
Slab down or base: This is an amount to help you lay the foundation of your property. It can cover the levelling of the ground, as well as the plumbing and waterproofing of the foundation.
Frame stage: This is an amount to help fund the build the frame of the property. It can cover partial brickwork, roofing, trusses and windows.
Lockup: This is to help you put up the external walls and put in windows and doors (hence the term ‘lockup’, to make sure your house is lockable).
Fit out or fixing: This is to help you install the internal fittings and fixtures of the property. It can cover plasterboards, the part-installation of cupboards and benches, plumbing, electricity and gutters.
Completion: This is for the conclusion of contracted items (such as final payments for builders and equipment), as well as any finishing touches such as plumbing, electricity, and overall cleaning.
For each stage of the construction process, you will usually have to confirm that the work has been done, complete and sign a drawdown request form, and send it to the construction department of your lender. Your lender may also request an invoice from your builder for the cost of the work done.
How to get a construction loan
Gaining approval for a construction loan is a different process to applying for a standard home loan on an existing property.
In addition to being subject to normal lending criteria and income and expense documents, banks and lenders normally require you to provide documents including council plans and permits, a copy of your fixed-price building contract (for cost-plus contracts this will differ) and any applicable insurance (such as public liability insurance and builders all risk insurance).
When you apply for a construction loan, the lender may consider the expected value of the property upon completion of construction, as well as the total amount required to pay the builder. An independent property appraiser will then typically estimate the expected value of the property when completed. The lender will typically also require further valuations and inspections during the project.
If the loan is approved, your lender will give you a loan offer. You will then have to make a deposit, as you would with most other types of home loans. This acts as security at this stage of construction. A larger deposit can help to convince your lender that you are a less risky borrower. You’ll typically need at least a 5% deposit, keeping in mind that you may have to pay lenders mortgage insurance if your deposit is less than 20%.
An owner-builder loan is specifically designed for people who intend to build the house (or contract trades directly) without the help of a professional third-party builder.
Many lenders only finance construction of homes that are built by licensed builders. Lenders may be hesitant to accept applications for owner-builder loans, as they use the property as security against your mortgage. If you’re building this property yourself, you are not considered to be a licensed builder and they may consider you to be a higher risk.
Lenders who do give owner-builder loans may limit the maximum loan to value-ratio for the loan. This means you may need to pay a higher deposit than you would for a typical construction loan. An additional interest rate loading or fees may also apply to owner-builder loans.
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