We know construction is complicated and can be stressful. This guide will outline what you need to know about building or renovating your home with a Construction Loan.
Read here for more information about the $25,000 HomeBuilder scheme.
Contents
What is a construction loan?
Can you use a ‘standard’ home loan instead of a construction loan?
Do I need a construction loan?
What if I am buying house and land? Should I have a construction loan?
How do progress payments to the builder work?
How big of a deposit do I need for a construction loan?
Can you include the cost of work completed by other contractors?
How do I get a construction loan?
How do I choose the best construction loan lender?
Owner builder construction loans
Need more help
What is a construction home loan?
A construction home 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 home loans designed for people buying an existing home. These are:
Progressive drawdown - That is, you receive instalments of the loan amount (‘progress payments’) at various stages of construction, rather than receiving it all at once at the start. You generally only pay interest on the amount that is drawn down, as opposed to on the whole loan amount.
Interest Only - 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. It doesn’t make much sense to be repaying principal at the same time that loan is still being drawn down.
As-If Complete value of the property is determined by a valuer is used assess the value of the lender’s security. This be a higher than the current value of the property or vacant land.
Restrictions on variations – Changes to the scope of work or building contract must be notified to the lender. Significant changes will require a revaluation of the completion value to be acceptable to the lender and may disrupt progress payments.
Can you use a ‘standard’ home loan instead of a construction loan?
You may be able to use a standard home loan if you have sufficient equity. This could lead to a lower interest rate and allow you to easily deal with variations.
However, there a number of disadvantages:
Fully drawing and paying interest (and possibly principal) on the loan from day one. This could be mitigated by placing any not-yet-spent construction money in a 100% offset account against your loan, although there can sometimes be additional costs associated with this.
Lower assessed value - If you are knocking down and rebuilding your house, the lender will only take into the account the value of the vacant land as security (as opposed to the completion value). This means they would not see the value of your equity in a completed property.
No third party checks - Although the lender and its valuer has no responsibility to you for the quality of work undertaken by the builder/contractors, the progress payment regime will means that there is another person (the lender’s valuer and not just you) inspecting the site and certifying that the building works have been satisfactorily completed as per the approved building stage and in accordance with the approved plans and specifications provided to the lender. The lender will not make any progress payments (including the first and the final) unless the valuer certifies.
Do I need a construction loan?
Given these disadvantages, we generally recommend using a construction loan for construction and major renovation needs. You can also consider refinancing a construction loan into a standard home loan once your home is fully built. At this stage you likely to be able wider range of options with lower interest rates.
What if I am buying house and land? Should I have a construction loan?
If you’re buying the a house and land, you may want to consider splitting the loan into a land loan and construction loan. The slight advantage of this is you won't need to pay all of your required funds in at the time the land settles as these are separate loans with different deposit requirements.
If you are purchasing the house and land under a turn key contract, a standard loan will be more suitable.
What if I'm renovating? Do I need a construction loan?
If you are doing a major renovation and you need the lender to assess the value of the property As-If Complete to advance you loan amount, then you will need a construction loan as a standard loan will based upon the current value.
If are knocking down and rebuilding, you are most likely going to require a construction loan so that the lender will assess the value of the property past the knock down through to the value of the new dwelling.
How do progress payments to the builder 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.
1. 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 your foundation.
2. Frame stage
This is an amount to help you build the frame of your property. It can cover partial brickwork, the roofing, trusses and windows.
3. Lockup
This is an amount 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).
4. Fitout or fixing
This is an amount to help you install the internal fittings and fixtures of your property. It can cover plasterboards, the part-installation of cupboards and benches, plumbing, electricity and gutters.
5. Completion
This is an amount 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.
At each stage, the following steps will take place prior to a progress payment being made.
Builder invoice - Your builder will provide you with an invoice for the completed work. This should be inline with the cost schedule approved by the lender.
Progress payment request - Once you have inspected the completed work and you are satisfied that the work has been completed, you must request a progress payment from the lender.
Progress inspection and valuation (if required by the lender) - A valuer will inspect the site and certify that the building works have been satisfactorily completed as per the approved building stage and in accordance with the approved plans and specifications provided. This step will always be required for the final payment and may also be required at any of the other progress payment. A lender will not make any progress payments unless the valuer certifies. There will a cost charged by the lender for this step.
Payment will be made directly from the lender to the builder. If you are paying for items out of your own pocket, these will need to be paid prior to the release of the progress payment by the lender.
How big of a deposit do I need for a construction loan?
It is possible to obtain a construction loan with a deposit as low as 5% of the As-If Complete value (without a guarantor) or 0% of the As-If Complete value (with a guarantor). However, LMI may be required and you will need to show that you have ‘genuine savings’ of 10% of the As-If Complete value.
However, experienced property owners budget for cost contingencies and delays as there is high probability of unforeseen costs or delays.
As a general rule, we try to ensure that you:
get approval for a slightly higher loan amount than you need; and/or
maintain a contingency of cash savings that you can use to pay for additional costs or advice that is outside the approved construction drawdown schedule (e.g. variations, building advice/consultants) ; and
keep saving during the construction process and try to avoid any large expenses until construction is complete; and
do not make plans based upon construction being completed exactly on time.
What are the different types of construction contracts and the implication of getting a construction loan?
You can generally categorise the types of construction contracts into the following:
Licenced builder (fixed cost contract) – You own/have purchased the land and engage a licenced builder to deliver a certain specification at a fixed price. Contractually, the builder is bearing the risk of increased costs. This is the most typical type of construction contract. Most lenders will only lend against this type of contract.
Licenced builder (cost plus or variable cost contract) - You own/have purchased the land and engage a licenced builder to deliver a certain specification at cost price plus a profit margin. Contractually, you are bearing the risk of increased costs. There may be reasons why a cost-plus contract may be appropriate such as: the builder is not able estimate the cost of construction and hence is not able to take on the risk of increased costs; or you are willing to take on the risk increased costs and able to negotiate a better deal with the builder. We consider this would only apply to you if you have significant experience in construction and managing builders (not many people) and have substantial cash savings to pay for increased costs. A disadvantage of cost plus contracts is that there are less lenders that will lend to you and the amount you will be able to borrow will be lower because of the lower cost certainty (typically up to 70% of the As-If Complete value.
Turn-Key House and Land Package - This is essentially not a construction project as you agree to purchase the land and house in one parcel once construction is complete. The builder/developer is bearing the risk of increased costs. The obligation to pay only arises when construction is complete. Hence, there are no progress payments and the loan is only drawn at completion. The loan in this situation is similar to a standard loan. A downside of this structure is that stamp duty will be assess on the full value of the property (not just the land). All lenders will accept this type of purchase.
Owner builder - This is where the own takes responsibility of managing their own residential building project. This includes where the you takes on the tasks of coordinating and contracting roles usually undertaken by an architect or builder. Only a few lenders will accept this type of contract. THose that do may require you to demonstrate that you have the necessary experience to deliver an owner builder construction project. See section on Owner Builders for additional requirements.
Can you include the cost of work completed by other contractors?
In some cases, you may have part of the work by a contractor other than your builder and outside the main construction contract.
Some common examples are:
Swimming pool
Pergola
Driveway
Power pole / power connection
Landscaping
Site clearing
Shed, dam or other hobby farm
If you have a formal written quote for this work, you can get the lender to extend the loan for these costs provided:
have a formal written quote for this work
it is included in the initial approval; and
it is only paid after the completion of the main house
How do I get a construction loan?
Call LoanCaddie to commence the process of obtaining a construction loan or apply here.
Getting approval for a construction loan is a different process to applying for a standard home loan on an existing home.
The pre-approval process to determine your borrowing power for a construction loan is the same as a normal loan. You will need to provide details of your income and expenses.
For the full approval, you’ll typically need to provide the lender with additional documents including:
council plans and permits
a copy of your fixed-price building contract and
any applicable insurance (such as public liability insurance and builder’s all risk insurance).
an As-If Completed valuation – this can be arranged by LoanCaddie.
Quantity surveyors report for larger construction projects (e.g. over $1m).
If your loan is approved, your lender will give you a loan offer. You can then make a deposit to the builder (typically 5% of the contract price).
How do I choose the best construction loan lender?
Construction is a complicated process with additional risks above just owning a property. It is recommended that you deal with a lender that has significant experience with construction as there will be a number of interactions regarding progress payments during the construction period. Getting the best interest rate should be a secondary consideration as you will be able to refinance after construction is complete.
We recommend that you speak to one of our advisers to discuss the best approach picking a lender to suit your situation.
Owner builder construction loans
One type of construction loan is an owner builder loan, which is specifically designed for people who intend to build the house themselves without the help of a professional third-party builder. In this case, owner builders are also not registered builders.
Many lenders only finance construction of homes that are built by licensed builders. There are a lower number of lenders that are willing to lend construction loans with owner builders.
Lenders who do give owner builder loans may limit the maximum loan to value-ratio for them. 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 builders.
There also additional requirements.
You will need to engage the services of an Independent Adviser to complete required costings and ongoing inspections.
You will need to pay for materials out of your own pocket before the lender will release funds to pay for it. This is because progress payments cannot be made for materials on site that are not affixed to the building. You cannot use receipts for materials to establish customer contribution/cost to complete. Funds are released strictly against the cost to complete test provide by the valuer. (See cost to complete test below).
Cost to compete test - The lender will also order a progress Inspection via their valuer which will include an estimate of the cost to complete the construction. Funds will only be released if the cost to complete (as per the valuer) does not increase. If it does, the lender may withhold releasing funds until the undrawn loan balance is sufficient to cover the balance of construction as advised by the valuer. i.e. you will need to pay for cost increases/variations out your pocket first.
Need more help?
We recommend that you consider having the following team of advisers to assist you in dealing with lenders, builders and councils during the construction process.
LoanCaddie mortgage adviser – to advise on obtaining finance and the funding process
Building consultant(s) – to review the commercial aspects of the construction contract, selecting a builder, changes in the building works, variations to the contract or cost estimates, construction progress
Lawyer – to review the legal validity of the construction contract and land purchase (if any) and execute settlement of the land (if any)