How a Construction Loan Works: Simple and Easy-to-Understand Guide to Construction Financing
Ever wonder how a construction loan works? Do you think it’s the right time to build a home with the help of such a loan?
The Australian government is hoping to build 1.2 million new homes in the next five years. That’s an ambitious figure, equalling about 20,000 homes per month. While the jury is still out on whether this goal is attainable, the government is offering a range of schemes designed to get as many new homes built as possible. In turn, borrowers are now showing a growing interest in construction loans.
What is a Construction Loan?
A construction loan is a finance product specifically designed to fund the building of a new home. Unlike traditional mortgages, which provide you with cash upfront, construction home loans will release funds in predetermined stages throughout the project. This effectively reduces the amount of interest you’ll be charged while the project is underway. Once your house is completed, the loan may be converted into a traditional mortgage.
What Are the Different Types of Construction Loans?
Construction finance can be structured to suit the needs of the borrower. The most common options are:
- Construction-to-Permanent Loans: These loans automatically convert to a traditional mortgage once the project is completed.
- Stand-Alone Construction Finance: This type of loan has a much shorter loan term (designed to suit the length of the project). Once construction is completed the borrower will need to repay the loan in full. This can suit borrowers who are planning to sell their existing home once the new home is ready.
- Owner-Builder Loans: These loans are for individuals who will be building their own home, rather than hiring a builder.
Construction Loans Australia: What Is the Process?
Construction finance loans generally have 4 distinct phases, including:
1. Pre-Approval
A borrower establishes their borrowing capacity and obtains pre-approval from their preferred lender.
2. Application
The borrower submits detailed plans, a scope of work and a proposed contract from their builder to the lender. They’ll also need to provide proof of income, ID and other documents required for a standard mortgage application.
3. Construction
Funds will be released to the builder in stages as the project progresses. The lender may require inspections to verify each stage has been completed before they release the funds.
4. Conversion
Once the construction phase is complete, the loan may be converted into a traditional mortgage.
How Are Funds Released with Construction Home Loans?
Most home construction loans will use the progress payment schedule recommended in the HIA New Homes Construction Contract. This outlines what percentage of the total project cost should be paid as each stage of the project is completed. Standard construction financing will include 6 payments, including:
- Initial Deposit: 5% of the contract
- Base/Foundation Stage: 15% of the contract
- Frame Stage: 20% of the contract
- Lockup Stage: 25% of the contract
- Internal Fix Stage: 20% of the contract
- Project Completed: Remaining 15% of the contract
How Is Interest Charged on Home Construction Loans?
A construction loan works a little differently from a regular home loan. Here’s how it typically operates:
Interest-Only During Construction: While your home is being built, you only pay the interest on the loan. This is called “interest-only payments.” You don’t have to pay the full loan amount yet, just the interest on what has been used so far. This keeps your payments lower while construction is happening.
Drawdowns (Progress Payments): Instead of getting the entire loan amount at once, the lender releases the money in stages. These are called “drawdowns” or “progress payments.” You pay the builder after each stage of construction is completed (e.g., slab, frame, lock-up, etc.). And the interest is paid on these drawdown amounts as the build progresses.
Transition to Principal & Interest (P&I): Once your home is fully built, your loan switches from interest-only payments to regular “principal and interest” (P&I) payments. This means you start paying off both the loan amount (principal) and the interest.
In summary, during the build, your payments are smaller because you’re only paying interest. Once the home is finished, you start making full payments to gradually pay off the loan.
Ask a Trusted Broker About Construction Loans
Construction finance can be the ideal choice if you want to build a new home. However, a construction loan can be more complicated. So, your first step should be contacting an experienced mortgage broker.
For personalised advice on construction loans, contact North Brisbane Home Loans today. Our team can help you navigate the complexities of construction financing and tailor solutions to your specific needs.
Patrick Cranshaw, a Certified Mortgage Professional for over 21 years, founded North Brisbane Home Loans in 2002. His career began with ANZ Bank in New Zealand, where he progressed over 16 years to a Business Banking role in Virginia. After moving to Brisbane in 2000, Patrick led the QLD market for a home loan agency, helped set up the REMAX Real Estate Finance division, and practiced as a broker.
