What is a construction loan and how does it work?

Borrowing to build a new home is a very different process from borrowing for an established one. In fact, some lenders who happily offer mortgages for existing homes actually don’t offer construction loans, which they consider too much work or too much risk. Often they don’t have the systems to monitor and process the payments for the stages of a construction loan.

The key differences are, unlike finance for an established home, where the full purchase price is generally made in one or two transactions plus the security is valued more easily as it is an established home and it can be taken as security as a completed property. With Construction Loans payments for the land and build occur at different points in the process. Initially the land will settle first and then the draw-downs for the actual build will commence.

In a nutshell, a construction loan uses the land value plus the value of the build contract as the security. Commonly any deposit is contributed towards the land and then the borrowed funds are used to contribute to the stages of the build.

The lender will also assess your financial situation, the same as they would for a regular mortgage, taking into account that they will be financing a home that doesn’t exist yet. To that end, there will be different valuation requirements and will be contingent on other things such as building permits, council plans and verifying the builder and their qualifications and insurance etc.

Once all the paperwork has been submitted and the lender has approved a total amount, you’ll only draw down on the loan as construction invoices need to be paid. Typically, there are five progress payments made directly to the contractor after the completion of each stage:

  1. The laying down of the foundations or footings of the home.
  2. When the frame of your home is in place, usually including roof trusses, the roof and windows and doors.
  3. Lock-up stage once the exterior of the home is finished and can be secured.
  4. Internal fit-out is complete, such as internal walls and doors, basic cabinetry etc.
  5. Completion, when all contractual requirements of the builder have been satisfactorily delivered and your new home is ready to move into.

By the time the completion stage has been paid, the full amount of the loan has usually been drawn down and the loan officially becomes a mortgage.

A major benefit of the progress payment system is that you only pay interest on the amount drawn down, not the remainder still being held by the lender. Unfortunately, the downside is that, for some lenders, this staged system can be slow, drawn-out and nerve-wracking. All these can cost the owner and the builder time and money, delay the next stage, or even disrupt final handover.

The other potential challenge when building a home, is all the different parties and elements involved, from financing and buying the block to re-negotiating finance to build, managing personal finances, dealing with legal aspects, choosing the builder and, if you’re investing, finding and managing good tenants. Fortunately, that’s where the WhiteStar Group really comes into its own.

We are not just brokers. We have everything under one roof, from finance, property selection, conveyancing, property management, and personal tax accounting. This allows us to provide a uniquely streamlined, integrated one-stop-shop service, and puts our experts at your call, from negotiating finance to, building, settlement and finally renting the property out.