If you’ve never built before, then getting your head around a construction loan can be confusing. Once you understand that these loans work a little differently to conventional loans, it becomes much easier. We’ve broken down what a construction loan is, in detail, so that you won’t lose any sleep over the logistics when it comes time to build.
What’s a construction loan?
Simply put, a construction loan is a type of loan designed primarily for people who are building a home. This loan only applies to new properties, so anyone buying an established property is unable to get the same type of funding.
Construction loans are designed to work in conjunction with the building process and require regular payments as completed stages of construction occur. These payments are called ‘progress payments’, which is when the borrower releases some of the funds approved by a lender to the builder.
Most construction loans are interest-only for the duration of the build, which a lender sets at 12-months, so while your home is built, your costs are kept to a minimum. After this period, the home loan will revert to principal and interest.
Most lenders offer construction loans, but not all, so check that your lender provides this type of finance before applying for a loan.
How are payments deducted with a construction loan?
Progress payments when building typically take place in five stages, though some builders may have different schedules, which you should find out before you sign any contract. It’s also important to ask about fees, as most lenders charge you when they make a progress payment – also known as a progressive drawdown.
The main stages of building when progress payments occur are:
- Slab or base down – This stage of payment covers the foundations of the home, as well as plumbing and waterproofing.
- Frame up – This section of the payment covers the house frames, roofing and windows.
- Lockup – This drawdown covers the brickwork and external doors.
- Fixing or fit out – This amount covers the internal walls, doors and cupboards, as well as toilet and bathroom fittings.
- Completion – This payment covers the finishing of walls and ceilings, as well as painting, electrical appliance fitting and the final clean and presentation.
How do construction loans work?
When you first apply for a construction loan, your lender will need to see a copy of the building contract. Lenders also request an independent evaluation of the estimated value of the property at the time of completion. This valuation ensures that they are making a sound investment. If satisfied with the figures presented, then your lender will then agree to lend you a specified amount. If this amount does not cover the full loan cost, then you’ll need to pay the shortfall or balance owed using your own funds.
Let’s say you want to take advantage of a house and land package worth $480,000. Your lender values the property and also looks at your financial situation. Based on your current circumstances, they agree to lend you 80% of the value, or $384,000, which means you’ll need to come up with $96,000 to cover the shortfall.
Under new legislation, the short-fall is payable at the time of land settlement. Therefore, you’ll need to make sure you have these funds available or you may jeopardise land settlement.
Does the construction loan cover contract changes?
You must also be aware that any other costs you incur, which were not in the original contract, will need to be covered by you. For example, if at the time of selecting your fittings for the new home, you choose designer items instead of the standard included in the contract, which cost an additional $2,500, you’ll need to pay this expense at the time of completion.
However, there are exceptions to this rule. Some lenders will allow you to increase your loan to cover more substantial expenses, but you’ll typically need to apply at least a month in advance to cover the shortfall.
What are the advantages and disadvantages of construction loans?
Before you jump into a construction loan, it’s essential that you find the right product for you and your circumstances and consider interest rates, fees and features, as well as construction terms. By comparing these, and then negotiating with lenders, you’ll get the best possible deal.
- Financial protection: By making progress payments, rather than paying a lump-sum up-front, you cover yourself against financial loss. You also ensure that the work is completed to a satisfactory standard before you provide the builder with any more funding.
- Reduced interest: If you’re only making partial payments then you’ll only incur interest on the amount that you’ve drawn-down. You won’t pay interest on the money left in the bank.
- Loan-deposit: Construction loans typically have a higher loan-to-value-ratio (LVR). So, you’ll need to make sure you have an adequate deposit to cover additional costs.
- Progress payments: Typically, your lender will need to assess work carried out before they’ll release the funds for a progress payment. This process can be time-consuming and frustrating.
- Higher rates: Construction loans often attract higher interest rates, so it’s important to do your homework before signing a contract so you don’t end up paying more than you have to.
Are you thinking of building your own home, but aren’t sure where to start? eChoice’s expert brokers can help you understand the market and simplify the process of applying for a construction loan. We have access to hundreds of products, so we’ll find you a competitive rate.
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