How does a construction loan work?

By Mark Rosanes | 11 Dec 2020

A spate of government grants and record-low interest rates have created a favourable environment for Australians to build their own homes – and many have taken advantage of the opportunity.

Seasonally adjusted figures from the Australian Bureau of Statistics (ABS) reveal that loans for the construction of new dwellings have spiked 11.5% in October, rising for the fourth straight month since the federal government announced the HomeBuilder scheme in July.

The number of loans for new home-building went up to 6,631 in October, representing an 82.8% jump year-on-year. The increase has pushed up the monthly value of loan commitments to $2.85bn, hitting a new high since records began in 2002, and was the largest contributor to the 0.8% overall rise in new owner-occupier housing loans.

Housing Industry Association (HIA) economist Angela Lillicrap says the HomeBuilder program was the catalyst for improving consumer confidence in the housing market, but added that other housing incentives, including record-low interest rates, have also played a role in strengthening the market.

Recently, the Reserve Bank of Australia (RBA) has decided to make further adjustments to the cash rate, lowering it to another historic low of 0.1%. The central bank also indicated that rates would stay at this level for at least another three years, giving potential home buyers a sense of certainty.

With all these incentives in place, it is not surprising that many Australians are lining up to seize the chance to build their dream property. However, getting a construction loan is a complex endeavour that requires ample research and preparation. Here are some of the basic things you need to know when applying for a construction loan.

What is a construction loan?

A construction loan is a type of home financing designed to assist with the funding for building a new house or doing a major renovation on an existing dwelling. It covers all the expenses incurred during construction.

This type of financing works differently and is more complicated than a standard home loan, which is used when purchasing an established property, for a number of reasons. For new builds, assessing the value of the property can be more challenging as the house does not yet exist. This situation may also result in the borrowers being charged with a higher interest rate.

Construction loans also often charge interest-only repayments for the period of the build, which initially runs at 12 months. Once construction is done, loan repayments go back to principal and interest for the duration of the mortgage term.

How do construction loans work?

Another major difference of construction loans from regular home loans is the way repayments are calculated. Lenders often divide the loan into several stages, called progressive drawdown, and make payments on each stage. The stages may vary from lender to lender but typically consists of the following phases or drawdowns:

First stage: Slab down or base

The first drawdown covers the cost of laying the foundation of the property. This may include levelling the ground, installing plumbing, and waterproofing the base of the home.

Second stage: Frame

This portion of the financing pays for the cost of framing the property. It also includes the construction of trusses and windows, roofing, and partial brickwork. 

Third stage: Lockup

This stage is called lockup because it involves all the processes needing to make the property “lockable.” The amount covers for the cost of putting up external walls and insulation, and installing windows and doors.

Fourth stage: Fitout or fixing

During this drawdown, the lender pays for the installation of internal fittings and fixtures in the property. Coverage may include internal cladding, tiles, and partial installation of shelves, cupboards, and cabinets. The amount also covers the installation of plumbing and electrical systems.

Fifth stage: Completion

This part of the financing covers the expenses for the finishing touches, including painting, polishing of walls and floors, installation of fences, and overall cleaning.

It is advisable for the borrowers to do a thorough inspection of the property once the construction has been completed to make sure that the house is built according to plan. Any issues or additional work needed must be communicated to the builder within three to six months after the property has been constructed.

How is interest calculated in a construction loan?

Another unique feature of a construction loan is how interest is calculated. Most lenders determine interest charges based on the funds spent as the loans are drawn down at specific stages of the construction. To illustrate, if by the fourth progress payment, only $250,000 of a $350,000 loan has been used, interest will only be charged on the spent $250,000.

The loan also remains interest-only for the duration of the construction. Once the property has been built, the borrower has the option to ask the lender to change the loan to principal and interest or continue with an interest-only scheme.

Some homeowners choose to either refinance their loans after construction is completed or use an end loan, while others covert their loans to a standard mortgage.

How do you apply for a construction loan?

Similar to standard home loan applicants, borrowers taking out a construction loan are subject to normal lending criteria, meaning they need to provide details of their income and expenses. However, they also need to submit additional documents – including the following:

Building contract

This document outlines the construction stages, progress payment schedule, timeline, and costs of building the property.

Building plan

This document shows the layout and size of the house being built.

Quotations

This document shows the estimated expenses of additional features in the property, including solar panel installation, pools, or landscaping. Lenders may look at these add-ons to assess if they may boost the value of the home.

Owner-builders, or borrowers who will conduct the construction themselves, may also be required to provide specific documents, including copies of council certified approved plans and permits, licenses for construction works, outlines of full construction costs, timelines, invoices, and insurance policies.

Once approved, the borrower needs to make at least a 5% deposit. However, just like a standard home loan, any deposit less than 20% of the loan amount may require a lender’s mortgage insurance.

Top Suburbs : sth toowoomba , flemington , alexandra hills , westmead , south brisbane

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