Construction loans guide: flexible funding for your build or renovation project

What is a construction loan, and how is it different from a home loan?

A construction loan - or building loan - is specifically designed to fund a major renovation to a property, a knock down rebuild or if you are building a new home from scratch. They are not meant for smaller projects like a kitchen or bathroom renovation.

The key feature of construction loans is that they release funds in instalments, as your project reaches key milestones in the building process. These are known as progress payments or 'progressive drawdowns'. These payments are made directly to your builder by your lender as they complete a stage, once each stage is signed off. This is a key difference from a home loan where you receive a lump sum to purchase a property, and then repay it over a long timeframe. 

Let’s now look more closely how construction loans work and what you can expect at every stage of the building process.

How does a construction loan work?

Most lenders structure a construction loan to operate on an interest only basis during the construction phase. It then reverts to a standard principal and interest loan once your renovation project or building project is completed. This means you only pay interest on the amount you have used or drawn down on.

Let’s look at how interest payments work in practice, with a real-world example.

Example: If by the halfway stage of the construction phase you have utilised $150,000 on a $400,000 loan, you only get charged interest on $150,000 -  minus the amount you have already paid back.

In general, construction loans have a variable rate, with a maximum LVR of 95%. The max LVR varies depending on the specific lender.

Your construction loan payments will be based on the timings of the fixed-price building contract your builder provides. Besides outlining the total cost of your project, the contract will also specify all the defined costs at timed segments or stages. To release funds for the staged payments lenders will require to see documentation confirming works are complete, which typically includes:

• A Progress Claim Certificate.
• Copies of all your builder’s claims, invoices and receipts.
  

In terms of the construction loan stages, progress payments are typically paid in five or six stages:

1. Deposit (5% of payment) - Payment to builder to start the project
2. Slab down or foundation (15% of payment) - Levelling site, foundation laid, plumbing
3. Frame up (20% of payment) - Construction of roof trusses, windows, and some brickwork
4. Lock up (20% of payment) - External walls erected, insulation, windows and doors
5. Fitout or fixing (30% of payment) - Internal fittings and fixtures installed, tiling, cabinetry and cupboards
6. Completion (10% of payment) - Finishing touches like painting, appliance installation, fencing and cleaning up

Appraisers typically visit a construction project at the slab stage and then again on completion. When the final progress payment is due you will need to provide your lender with the following documents:

• A copy of the occupancy certificate or interim occupancy certificate if it is a new home.
• A copy of the final inspection certificate for renovations and extensions.
• A copy of the building insurance and fire policy. 
  

When the loan is fully drawn down your lender will then notify you that the loan is reverting to a standard principal and interest loan with an outline of your new repayments. 

Let's now look at how you qualify for a construction loan, and what documentation lenders are looking for. 

How do I qualify for a construction loan?

Much like a home loan, lenders are looking for similar criteria when you apply for a construction loan. This includes proof of income, a positive credit rating and a declaration of all your current obligations to creditors, including credit cards and any other loans. You also need to put a deposit down - at least 5 per cent, though 20 per cent means you will avoid paying Lenders Mortgage Insurance (LMI). 

In addition to this documentation they will also require the following paperwork related to your construction project: 

• Council plans and permits
• Professional building plans
• Proof of land purchase
• A contract with a licensed builder 
• Proof of builder's licence and insurance
• The builder’s bank account details for progress payments
  

Your lender will also use an independent property appraiser/valuer to estimate the expected value of your property when completed. Using all this information your lender will calculate how much you need to borrow for your project. The appraiser will also typically visit your project throughout the construction phase to do further valuations and inspections.

Now you have an overview of this type of loan, let’s look at the pros and cons of taking out a construction loan. 

What are the pros and cons of construction loans?

Like any financial product you need to work out if a construction loan suits your needs and specific circumstances. Knowing the pros and cons allows you to make an informed decision about your options. 

Construction loan pros: flexibility and cashflow

Construction loans give you some definite advantages, including:

• Flexibility and cash flow to fund your project.
• Interest only payable on the funds you use, not the full loan amount.
• Builders are only paid for the work they have completed.
• Lower repayments as your project progresses.

Construction loan risks: 

Construction loans also come with some disadvantages or risks, including: 

• Higher interest rates than standard home loans.
• More fees may apply, such as an upfront construction fee, milestone payments processing fees or valuation fees.
• Construction can be delayed or go over budget. 
• The final value of the house can differ from your expectations.
  

Now let’s cover all the other FAQ’s people have about this type of loan.

Construction loan: FAQ’s

What happens if my project has cost overruns?

If there are cost overruns on your project, these will generally have to be covered by you, though some lenders allow you to add them to your existing loan.  

How much can you borrow for a home construction loan?

Lenders will use a number of criteria to assess how much you can borrow for a construction loan. The first is your income and ability to repay a loan, how much deposit you have or how much equity you have in your current home, and the projected value of the completed property.  

Can you use the equity in your home or land for a construction loan?

Yes, you can use the equity in your home to fund your construction loan, provided you have enough to satisfy the lender’s requirements. The equity in your current home could help fund the deposit requirements for the construction loan. If you own land then there is a distinct product, land equity construction loans, to fund your building or large renovation project. 

What is an owner-builder mortgage?

If you plan on being hands-on and managing your project as an owner-builder, there are separate products called owner-builder mortgages. These do come with stricter conditions, as owner-builders are considered riskier by lenders - who often limit the loan amount to 60 per cent of the total costs. Many lenders do not offer owner-builder mortgages so you might need to look for a specialist lender.

Apply for a construction loan with Yard

Wondering why you should consider us for your construction loan? Here is why we think we stand out:

• Our application process is hassle-free and fully online
• You get a dedicated loan consultant who works with you from start of application through to settlement
• We can provide a pre-approval that’s valid for 90 days, which gives you confidence to go to bid at an auction or negotiate a building contract with a builder
  

Have any questions about our construction loans? We’re here to help, and our friendly local team are available to chat at a time that suits your schedule.