What is a construction loan?

30th Aug, 2023 | Articles, Construction Loan, Loan Features

In this article:
Prepare for insights into construction loans in Australia. Discover the unique features along with considerations. Delve into this concise guide for a clearer understanding.

Understanding Construction Loans in Australia

So you’re thinking about renovating? Or maybe it’s time to look at building your dream home. The first question on your mind is likely “How am I going to pay for it?” A construction loan might be the answer.

A construction loan is a specialised type of loan designed to finance the construction of a new home or significant renovations to an existing property. Unlike traditional home loans or mortgages, which are typically used to purchase a completed home, construction loans are intended to cover the costs associated with building or renovating a property from the ground up.

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How does a construction loan work?

Due to its specialised purpose, a construction loan operates differently from a conventional home loan. Let’s take a look at some key features and characteristics of construction loans:

1. Short-Term: Construction loans are usually short-term loans, with terms ranging from six months to a few years. They are meant to cover the period during which the construction takes place.

2. Interest-Only Payments: During the construction phase, borrowers often make interest-only payments. This means they only pay the interest accruing on the loan amount, rather than paying down the principal balance.

3. Disbursement in Stages: Instead of receiving a lump sum upfront, borrowers typically receive the loan funds in installments or ‘draws’ at different stages of the construction project. These stages are often determined by milestones or specific phases of construction. This phased disbursement, known as “progressive drawdown,” aligns the loan amount more accurately with your ongoing construction costs.

4. Higher Interest Rates: Construction loans typically come with higher interest rates compared to traditional mortgages. This is because they are considered riskier by lenders due to the uncertainty associated with construction projects.

5. Credit and Documentation Requirements: Lenders often have stricter credit and documentation requirements for construction loans. They may require detailed construction plans, cost estimates, and a qualified builder.

6. Transition to Permanent Financing: Once the construction is complete, the borrower usually needs to transition the construction loan into a permanent mortgage or long-term financing. This process is known as “conversion” or “refinancing.” The borrower may need to reapply for a mortgage, and the terms of the permanent loan may differ from those of the construction loan.

7. Down Payment: Borrowers typically need to make a down payment on a construction loan. The down payment requirement can vary but is often higher than that of a traditional mortgage.

8. Insurance: Borrowers will be required to have a variety of insurance in place, including builder’s risk insurance, to protect against damage or loss during construction.

So how do I get a construction loan?

There is a lot of organisation when getting ready for a construction project. To give you an idea of the process, you may need to complete the following steps:

  1. Set your renovation or building goals- be clear about what you are aiming towards and keep your expected finances in mind.
  2. Build your construction team – select your registered builder, architect, and project manager if you need one.
  3. Get your documentation in order and to the bank – there is a lot of documentation to get sorted and it can take TIME. Basically, this includes your council plans and permits, required insurances and a fixed-price contract, and all need to be prepared to pass on to your lender for the next step.
  4. Get a valuation – The lender will want to carry out a thorough evaluation of your property and the proposed build to ensure your loan is both realistic and sufficient. They will also assess your ability to meet the loan criteria.
  5. Pay your deposit – Assuming you meet loan criteria and the bank is satisfied with your valuation and documentation, your final step is to pay your loan deposit. This varies but maybe around 20% of your agreed loan.

Some more good-to-know stuff…

How do drawdowns work?

Drawdowns refer to the payments made to the builders and suppliers at each identified stage in the build. As each stage is completed, and you are happy that the required work has been done to your satisfaction, you complete a drawdown. At this point, you will start paying interest on that amount. To do this the bank will require things like invoices and a progress claim certificate.

Once you have that occupancy certificate in your hands and the last drawdown is approved, you start your new repayments.

How do payments work on a construction loan?

Loans vary considerably in terms, however, in general, you may only pay interest on the amount drawn down during construction. These interest-only payments will gradually increase as you access more of the loan at each build stage. When the last drawdown is finalised, you’ll begin a new repayment regime that includes the balance of your loan.

Lenders may allow you to make additional payments into your loan at any stage which reduces your loan balance and means you may pay less interest.

Cost over-runs

Even if you’ve never undertaken a construction or renovation project, we all know they are unpredictable. When the budget starts to break (or the cost at each stage ‘overruns’) you may find that your lender is able to accommodate these costs. It may be the case, particularly for larger deviations, that these costs are something that you have to absorb. It is important to take these possibilities into account in the planning stage.

Looking to build a first home?

Whether you’re a first-time borrower or investor, the basics of a construction loan remain the same. However, the loan’s specifics, including interest rates, loan-to-value ratio, and down payment, may vary depending on whether the property is for personal use or investment. Particularly for first-time buyers, government incentives like the First Home Loan Deposit Scheme may help reduce the upfront costs, an advantage typically not available to investors. It’s essential to consult with a trusted mortgage broker to navigate these nuances and make a decision that best supports your financial situation.

Planning is key!

Listen to Mark Bouris & Stephen Koukoulas discuss declining building approvals

Construction loans can be complex, and they require careful planning and coordination between the borrower, the builder, and the lender. It’s essential to work with experienced professionals, including builders and lenders familiar with construction financing, to navigate the process successfully. Additionally, the specific terms and requirements of construction loans can vary among lenders, so it’s crucial to shop around and compare options to find the best fit for your project.

Thinking of completing a major build? It pays to know more about what’s going on in the construction industry in Australia right now: read on…https://yhomeloans.com.au/thinking-about-building-whats-changing-in-the-construction-industry-in-2023/

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