This is a type of loan you might come across if you’re starting from scratch with your home.
When building a new home you will not need the entire amount of the loan drawndown all at once. If you did this, you would be making interest repayments on the entire amount right from the start and not just on the amount needed at the time. Construction of a dwelling is generally divided into five stages. These are as follows:
- Purchase of the land
- The pad (floor – also known as ‘bearers and joists’ for wooden floors)
- Roof (usually including frames)
- Lock up
With a construction loan you can break up the drawdown of the loan amount into five progressive draws, which parallel the construction phases. As one phase of the construction is complete, you are able to draw down the next portion of the loan.
This means that interest is only being calculated on that amount which has been physically drawn down and you are only making repayments on the portion you have used. When construction is complete you can nominate which product or loan type your loan reverts to.
Most lenders will normally lend only around 60-65% of the land value for purchase and this is usually done as a land loan. Recently, however, some lenders are lending up to 90-95% of the land value, so it is a good idea to check with your lender how much they will lend.
When you decide to build and apply for a construction loan, the lenders will need to see, at minimum, council approved plans and a fixed-price building contract before they will unconditionally approve a construction loan.
If you have borrowed to purchase land and are looking to obtain a construction loan the value at which most lenders will estimate the completed package will be based on the value of the land plus the cost of the building materials for the dwelling. For example, if your land has been purchased for $150,000, and the cost to build was estimated at $80,000, the lender would put the total value of the house and land at $230,000. An identical ‘completed’ house on an identical piece of land next door to you may be worth $300,000.
If you need to borrow more funds for improvements such as landscaping, you may be able to get your property revalued by your lender once the building is complete.
After each phase is finished a valuer will normally go out to inspect it to make sure that the phase is complete according to the requirements set out in the fixed price building contract. Once the valuer is satisfied, they will contact the lender and authorise the next payment.
If you are concerned that you may need to pay contractors before the set phases are done you may want to consider obtaining a very small line of credit as part of the loan. That way you will be able to pay any urgent bills from the line of credit before the appropriate phase is complete, and then pay your line of credit balance to zero from the construction loan once the relevant phase is complete and the money has been drawn down.
To ease the financial burden during the construction phase construction loans are usually interest-only. The interest rate may be slightly higher than that charged on normal residential loans but should be less than that of a line of credit/equity rate.
Construction loan application checklist
Most construction finance applications are assessed according to the standard process and many of the same documents are required, along with a fully completed ‘build pack’ (or ‘Bank Pack’) which includes:
- Signed fixed-price building contract between borrower and a licensed builder tender
- Stamped, council-approved building plans
- Copy of builder’s insurance policy must-have features
- Interest-only repayments during construction and a switch to principle and interest repayments thereafter
- The ability to make extra repayments
- Flexibility – including redraw during the construction period. Will you able to switch to a more flexible product upon completion of construction? Some lenders offer a 100% offset account linked to the home loan which is a handy feature as it allows you to save on interest by parking any cash to this account
Saves interest because interest is calculated on the outstanding balance, not the maximum loan amount which has been agreed to, so you are paying less interest on the loan. For example, if the lender has agreed to lend you $200,000 but you have only drawn down $100,000 to pay for the land and $25,000 as an initial payment to the builder at this point, you are only charged interest on $125,000, not $200,000
During construction loan repayments are interest-only, payable only on the amount of the loan that has been drawndown, which means lower repayments.
Peace of mind
The fact that payment is delivered to the builder in stages means that cash is not paid out until the builder’s work can be inspected and approved by the borrower.
“A benefit of a construction loan is that a valuer will inspect each stage of your construction on behalf of the lender before they approve each progressive payment,” says Martin Castilla, finance broker for Smartline and guest lecturer at The Property School. “This means the lender is ‘double-checking’ the builder’s work and what they are invoicing for. It can provide some peace of mind for the new owner.”
The borrower can borrow against the value of the property as if it were completed, as opposed to borrowing only against the value of the land or the current property.
This saves the borrower time and money in terms of going back for more cash in case the fund runs out during construction