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How Construction Loans Work: Building Your Dream Home

If you’re one of the many with plans to build or renovate, then it’s only natural for you to start thinking about construction loans. What are construction loans? How do construction loans work? And what are the benefits of construction home loans?

Australia is a nation of builders and renovators. According to some of the most recent data available from the Australian Bureau of Statistics, 40,720 new dwellings started construction during the three months up to June 2023. Meanwhile, more than a third of surveyed homeowners have confirmed they’re planning to renovate within the next year. 

Obtaining the right home construction loan can feel like a huge undertaking, especially for first-time builders and renovators. However, finding the right loan to build your home with could save you substantial amounts of money and make the project a whole lot easier. Fortunately, you don’t have to navigate this process on your own; a mortgage broker can walk you through it step-by-step.

What are Construction Loans?

So, what are construction loans? They’re a type of loan product designed for borrowers who are planning to build a new home or renovate an existing one. They’re different from a traditional home loan used to purchase an established property, which is usually provided as a single lump sum.

In contrast, home construction loans let you draw down your loan in pre-determined instalments. This type of facility is also referred to as “progress payments” or “progressive drawdowns.”. Borrowers can draw individual payments from a pre-agreed loan amount at different stages of the construction.

How Do Construction Loans Work?

A construction loan helps you pay for your project as and when you need financing. This loan reverts to a regular home loan once the project is completed. But how do construction loans work exactly?

Your loan contract will include a schedule of progress payments that have been agreed upon by the builder and the lender. As each stage of the project is completed, the builder will issue a progress payment invoice. The lender will then make the necessary payment to your builder at each stage of the construction schedule. Once the construction project is completed and the final payment has been made, the loan will operate like a typical mortgage.

While contract details will vary, a typical construction loan schedule will often look similar to the following:

1.     Initial deposit 5%

2.     Foundation slab 15%

3.     Exterior frame 20%

4.     Lock-up 20%

5.     Interior fit out 30%

6.     Completion 10%

The maximum time frame for the complete drawdown of your loan is usually around six months. You may need to buy the land on a separate land loan if you don’t plan on starting the construction immediately.

How Is Interest Charged on Construction Home Loans?

While the construction work is in progress, you will only be required to pay interest on the amount that has been drawn down. So, theoretically, after paying the initial deposit, you will be paying interest on just 5% of the total loan. After the foundation slab is completed, this will increase to 20%, etc.

For example, if you had a $300,000 construction loan with an interest rate of 6%, your monthly interest charges would slowly increase from just $75 up to $1,500 by the end of the project.

Payment StagePayment AmountCumulative TotalMonthly Interest
Initial deposit (5%)$15,000$15,000$75
Foundation slab (15%)$45,000$60,000$300
Exterior frame (20%)$60,000$120,000$600
Lock-up (20%)$60,000$180,000$900
Interior fit-out (30%)$90,000$270,000$1,350
Completion (10%)$30,000$300,000$1,500

This kind of draw-down payment structure could save you a substantial amount of interest while the construction project is underway.

What Are the Lending Criteria for Home Construction Loans?

couple checking out a home being built using a home construction loan

To qualify for a construction home loan, you’ll need to meet standard lending criteria. You will also be asked by the lender to provide some specific documentation relating to your proposed construction project. This typically includes:

  • insurance provisions
  • council plans and permits
  • copy of your fixed-price contract with a builder
  • proposed Payment Schedule
  • proof of land purchase

The lender’s valuer will then estimate the on-completion value of the property and use this to assess your borrowing capacity. Future rental income will also be included as part of the valuation if you’re building an investment property, which can significantly increase the amount you can borrow. 

How Do Construction Loans Work for Renovations?

If you’re planning a renovation instead of a new build, then your eligibility for a construction loan will depend on the scope of the proposed project. Home construction loans will usually only be offered for substantial house renovations, such as a major extension or extensive remodel. This is because those sorts of renovation projects will add significant value to the property.

If you’re planning on a smaller renovation, such as a kitchen or bathroom remodel, then you’re unlikely to be approved for a construction home loan. But this doesn’t mean you’ll be unable to secure financing for a smaller renovation. The best thing to do is talk to a mortgage broker for some expert advice on what kind of financing would be most suitable for your renovation project.

What Are the Benefits of Construction Home Loans?

Construction home loans can be a fantastic option for borrowers who are planning to build or substantially renovate a home. The unique structure of construction loans means they’re ideally suited for projects that will be paid for using routine instalments. And because you’re only charged interest on the funds that have been drawn down, you could end up saving thousands of dollars by the time the project is completed.

Talk to a Mortgage Broker About Home Construction Loans

At ZEP Finance, we understand the complexities that are involved with applying for construction loans. Our team of mortgage and construction loan specialists can answer all of your questions, discuss the various options available, and help you get the financing you need. But it doesn’t stop there. We’ll also be there to assist at every key checkpoint of your construction loan contract to ensure a smooth process throughout the build.

If you want to get started with your construction home loan application or if you’ve simply got more questions, feel free to reach out to us today. We’ll be more than happy to help in any way that we can.

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