How do construction loans work? - All your questions answered!
Getting your house built from a vacant land is always thrilling but also challenging and sometimes overwhelming for many people. Compared to buying an established property with a regular home loan, the construction process has more risks involved and a buyer needs to do more homework to well prepare oneself.
What is a construction loan?
A construction loan is a lending option or type of loan that gives you funds to build a property. Lenders will pay your builder (or yourself if you’re an owner builder) over a few stages of your building process.
Construction loans have similarities to a standard home loan. This means they will have loan setup fees, a loan pre-approval process, option to have variable rates or fixed interest rates (with comparison rates advertised), an option for lender’s mortgage insurance, and more.
The main difference in the loan is that the funds are released gradually as building progresses and you as the borrower needs to provide interest only repayments during constructions before it “switches” over to a normal home loan.
What are the stages of construction?
Most commonly, the construction process is summed into 5 stages. A typical 5-stage building process can be as follows:
- Stage 1 – Slab/Base (including laying and plumbing the foundation);
- Stage 2 – Frame (including building the frame, partial brickwork and the roof);
- Stage 3 – Lock up (including external walls, doors and windows);
- Stage 4 – Fit-out/Fixing (including gutters, plumbing, electricity, and plasterboards);
- Stage 5 – Practical completion (including finishing touches, final plumbing, electricity, fencing, site cleaning and final payments).
One thing to note, though the preparation stage is normally not considered as a part of the construction stages, it is arguably the most important part of the whole process. It starts from getting the design right and the building compliant with Building Code of Australia and Australian Standards. You may need an architect, a building designer and/or licensed builders to be involved.
If the design and construction of the house is complex, you may require even more experts and specialists to work together to get the plan and the project right from the beginning. If this preparation stage is not correct, this will incur many unexpected expenses and time delays in order to have your house completed. Sometimes you might not even see the issues appear until a later stage of construction! A waste of your hard earned money.
For lenders who are willing to provide construction loans, they will generally require your building project to be completed within 24 months of the settlement date. Some lenders will allow for an extension, so this is not a strict timeline though the delay will definitely cost you more.
Two key construction loan concepts to understand
There are two key concepts to learn in order to understand how construction loans work: the building contract and the progress payment schedule.
Fixed Price Building Contract
In general, there are two types of building contract: Fixed Price Building Contract and the Cost Plus Building Contract. A Fixed Price Building Contract means that the total price of the construction of the house or property has been fixed and cannot be changed unless variations to the scope of work are made. A Cost Plus Building Contract means that there is no firm limit of the total price of the project and the owner agrees to covering all costs plus a profit margin of the builder. We explain more about the differences here.
For the purpose of getting a construction loan, nearly all lenders are looking for a Fixed Price Building Contract. It gives lenders much more assurance of the total cost, and enables lenders to do a “As If Complete” valuation upfront. Variations to the scope of works may be accepted, but lenders need to be notified as soon as any changes are made.
The reason for this is lenders ultimately want to reduce their risk when they choose to release funds to you. Having certainty of the end product, they are able to have valuations of the property before and after in order to determine how much to lend to you. Though in general Cost Plus building contracts are NOT acceptable by nearly all lenders, we do know lenders who are willing to accept with a maximum 70% LVR.
Please note: be aware of “house and land packages” trying to sell you with a split contract! You can learn more about the risks here.
Progress Payment Schedule
A progress payment schedule refers to a document which outlines when you are required to pay your builder as the construction of your house progresses according to the stages of construction.
Normally, you would need to pay a deposit of a fixed amount or a percentage amount (e.g. 5%) of the total construction cost. As each building stage completes (or milestones are hit), either you or your lender will pay your builder according to the progress payment schedule.
There are some guidelines that lenders follow in terms of the payment percentages for each stage. A typical requirement regarding the progress payment schedule is as follows (except Northern Territory):
In the Northern Territory (NT), there are more detailed rules regarding the maximum percentage for each stage.
Lenders will only start to pay builders after you have contributed your part at first. For example, if you are borrowing 80% of the construction cost, you will need to pay 20% at first, before the lender starts the payment to your builder. This means if Stage 1 and 2 of the construction only require 20% of the total construction cost, it means you are required to pay the builder for the first 2 stages and then the lender can pay the builder for the remaining stages.
To finalise the construction loan, in nearly all circumstances, your final progress payment will only be paid after a satisfactory final inspection is completed by a lender’s assigned valuer. The valuer will confirm that the construction has been completed in line with the original plans and specs as well as provide a valuation of the property in line with current market conditions for the area it is in.
Other documents may also be required, this includes but is not limited to: a copy of the occupancy certificate or interim occupancy certificate where only external items (for example, driveway and landscaping) are outstanding, and a copy of the building insurance.
What documents are needed to get a construction loan?
For a construction loan application, normal lending criteria apply. This means that you need to follow the lender’s regular assessment and requirements including incomes and liabilities. Apart from that, the following extra documents are needed for a construction loan.
- Signed Fixed Price Building Contract – including progress payment schedule;
- Council Approved Building Plans and Specs – you may provide a copy of the plans that have been or are to be submitted to achieve loan approval, but the approval must be provided before settlement;
- Variations & Quotes – if applicable;
- Insurance Policies – Builders Risk Insurance, Public Liability Insurance, Domestic/Home Warranty Insurance
- Quantity Surveyor Report – some lenders require this if the building contract costs over $1 million.
What’s the maximum LVR for a construction loan?
Normally, when we discuss the maximum loan to value ratio (LVR) for a construction loan, we need to consider a combined value of your land and the construction. The total LVR restrictions are in line with normal home loan restrictions. For example, if the total LVR is over 80% (i.e. you are borrowing more than 80% of the value of the completed value of land and house), then in most cases the lender’s mortgage insurance cost will be applied. Below are some example scenarios we have seen with our clients.
If you have enough equity in your land, you may then borrow 100% of the construction cost. For example, imagine that you purchased a vacant lot of land, for $500,000 and took out a $400,000 loan (80% LVR). And now, 1 year later, the land value increased to $600,000. If we assume your proposed building cost for a house is $300,000, this brings the total value of the land + building to be $900,000.
If your income and borrowing capacity allows you to get a maximum 80% loan (in this example $720,000 is 80% of $900,000), then it means you may borrow up to $320,000 ($720k-$400k) for this project. This $320,000 is more than the proposed $300,000 construction cost. Therefore, you essentially can borrow 100% of your construction cost in this case.
If you have an existing house on your land, and your construction involves knocking down the old building and starting the new construction, what will happen?
Let’s assume your current property has a land value of $800,000 and building value of $200,000. Your total home value is $1m and the existing loan is $800,000 (80% LVR).
Let’s assume that the cost to knock down and rebuild a new house is $400,000. This means that the final value of the entire project would be $1.2 million ($800,000 land value + $400,000 construction of new home). If we are borrowing at 80% LVR, this means $960,000 is available to borrow.
This means you only have an additional $160,000 to borrow for your construction cost ($960,000 total loan minus existing $800,000 existing loan). This means that you will need to contribute $240,000 ($400,000 construction cost minus $160,000 extra loan) of the construction cost, before the lender starts to release funds for construction.
Check with our Reservoir Finance construction specialist before getting confused of how much exactly you will be able to borrow, how much you need to contribute and what the payment timeframe looks like.
How do construction loan repayments work?
When it comes to construction loan repayments, there are several steps involved as it is not as simple as a standard home loan.
Step 1 - Requesting Progress Payments
When a certain stage has been finished by your builder, they will send you an invoice to pay. An invoice must have an official company letterhead, a licensed builder’s ABN, description of the related work of the stage, and the payment amount with GST. You will then need to send the invoice to your lender by yourself, or through your mortgage broker.
Step 2 - Progress Payments Being Made
After the lender receives the invoice, with proper verification and possible inspections, the lender will then make the payment to your builder. Confirmation of payment will be sent out to either you yourself or your mortgage broker.
Step 3 - Paying Interest Only Until Next Payment Drawdown
You will then start to pay the interest on the amount that the lender has drawn down. In other words, you pay the interest on the total amount that your lender has paid on your behalf to your builder. During the construction period, the repayment type will always be Interest Only. This is regardless of the type of construction loan repayment you selected (ie Principal and Interest repayment or Interest Only repayment in a longer term).
Step 4 - Conversion to Post-Construction Loan Repayment
After the final payment is made (your house is complete), your construction interest only period expires. If your construction period ends before the end of your approved interest only period, then your loan will be converted into Principal and Interest repayment automatically.
A review of the loan product with your lender directly or your mortgage broker is recommended in order to avoid any changes that are not in your best interest.
Ready to start building or renovating? Have more questions?
Building or renovating your dream home is ultimately an exciting and rewarding process. At Reservoir Finance, we understand this and wish to make the financing process as smooth as possible so you can focus your efforts on your project.
Reservoir Finance is an independent (not owned by a bank or lender) mortgage broker based in Sydney that services Australians worldwide! We always seek to put our customer needs first by our unique mantra of “responsible borrowing” (different from responsible lending touted by the banks and the media). Another way we put our customers first is to not charge any upfront fees for our service or any initial advice or consultation! In fact, we have not charged fees to 99% of our clients!
We would love to speak with you if you have any questions or need help with a construction loan. We will keep you informed, updated and where possible, give you choice with the best loan product(s) for your home, project or circumstances.