How Does a Construction Loan Work?

Deciding to build your own home is an exciting step for homeowners, but it can be costly if you don’t have enough savings to cover the expenses of a full build. Luckily, that doesn’t mean you can’t create or renovate your dream home. 

Construction loans exist for this very purpose.

Construction loans are different from regular home loans, so there are things you need to be aware of before deciding if it’s the right choice for you. 

In this article, we will answer the question, ‘how does a construction loan work?’ to help you in your decision-making process.

Understanding Construction Loans in Australia

Also known as building loans, construction loans are suitable for building projects like a knock-down rebuild, a significant renovation on an established property, or an entirely new home built on a vacant land lot. 

Unlike a regular home loan, construction loans work with a staggered loan structure. The key difference is that you don’t receive one lump sum upfront as you would receive with a traditional mortgage. Instead, construction loans are paid out from your bank directly to your lender. 

This type of payment structure is known as ‘progress payments’ or ‘progressive drawdowns’.

What are the Stages Involved in the Construction Process?

First, you’ll make your initial deposit to the lender, who will then enter you into a building contract and inform you (as well as your chosen licensed builder) when the construction project can start. 

Some lenders may only have the funds available for a predetermined period, so it’s generally best to begin building as soon as possible. Make sure your expectations and planning will fit within that period, as the bank will include the timeframe in your contract.

After you’ve received the go-ahead from your lender, you will need to pay the deposit to the builder. This deposit isn’t the same as what is required with a home loan, and usually only costs around 5% of your loan.

Once the deposit payment goes through, the building process can commence.

Construction stages will differ if it’s a complete build or an extensive renovation, but as the progress payments will occur at each step of the construction process, it’s useful to know what to expect – and how much it might cost.

Stage 1: Foundation

The first stage of building is the foundation slab:

• Timeframe: Generally, your slab will take a few days to pour (depending on the size of the foundation), and you can expect to wait around a week after pouring and curing for the concrete to reach the required strength it needs to allow framing to start. Sometimes it can take anywhere between 2–6 weeks depending on other factors like weather, humidity, type of cement, etc., so stay in contact with your builder for updates.
• Cost: Typically, laying the foundations of your home will take around 10–15% of your construction loan funds.

Stage 2: Frame

After successfully curing the foundational slab your builder will begin building your home’s frame, including walls, support structures, gutters, insulation, plumbing and electrical conduits. 

• Timeframe: Provided there aren’t any delays, you can expect to see your frame completed within 3–4 weeks. 
• Cost: Framing can eat into around 20% of your construction loan funds.

Stage 3: Lock-up

The third stage of your build will be the installation of external walls, windows, doors and roofing.

• Timeframe: If you’re building a one-storey house, lock up can take around four weeks. However, you may need to add a few more weeks to the timeframe if it’s a fairly large home, or has multiple stories.
• Cost: You can expect to pay around 20% of your funds for this stage.

Stage 4: Fitting

At this point, your home will look less like a work-in-progress and more like your dream home. 

The fitting stage will see your electrical and plumbing fixtures installed, such as your lights, powerpoints and taps. Your builders will install other fittings like countertops, ovens and skirting boards and waterproof all wet areas.

• Timeframe: This stage can take around 2-3 weeks.
• Cost: This will take up around 30% of your construction loan funds.

Stage 5: Completion

Final stages will be completed, including details like painting, fencing and site clean-up, and your new home will be almost ready for you.

How Do Progress Payments Work on a Construction Loan?

At each stage of construction, a progressive drawdown will be taken from the loan.

The lender will pay the builder’s invoices in progressive drawdown instalments, which is a great way to help you budget and successfully navigate potential cash flow challenges from large building projects.

You can successfully pay off each stage of your construction loan by passing each invoice over to your lender after receiving it from the builder. The bank will transfer the necessary funds directly to your builder, once you’ve authorised the payment.

And, until the construction has been completed, you’ll make interest-only repayments on your progressive drawdowns.

The major difference between interest-only construction loans and interest-only home loans is that with a construction home loan, your interest payments will increase at each completed stage as your owing balance will rise with the release of funds from the bank to the builder.

Your lender will complete valuations and inspections throughout the build to ensure things are progressing as they should be, and there aren’t any issues or flaws that could delay the build.

Once the builder has finished, the bank will do a final, detailed inspection to confirm everything has been built according to the initial building plans, building contract and specifications. 

If everything is approved, the bank will release the final progress payment to your builder, and you’ll be able to collect your new keys to your new home.

After you’ve moved in, you’ll start to repay the principal and interest on your construction loan for the remainder of the contracted loan term.

Pros and Cons of a Construction Loan

There are pros and cons to consider if you’re thinking about applying for a construction loan.

The Pros

Being able to build your own home is a fantastic opportunity, and there are definitely benefits of using a construction loan to do that, including:

• Flexibility and a clear payment schedule
• You’ll only pay interest on used funds, not the full loan amount
• Builders receive payment for work after it’s completed and approved

The Cons

A construction loan also has several disadvantages or risks, such as:

• Potentially paying a higher interest rate than you would on a typical home loan
• Upfront or ongoing fees may apply, like processing fees and valuation fees
• There could be delays or issues with construction, which can go over expected costs
• The property’s final value may not be what you were expecting

Conclusion

Building your own home or undergoing a huge renovation on your existing property doesn’t need to be as complex as it sounds. A construction loan can help you finance your project through the progress payment schedule, which lowers the risk of financial loss or difficulties in planning your budget. 

Feeling overwhelmed? That’s what we’re here for. Contact one of our expert mortgage brokers today to learn how we can support you throughout the construction home loan application!