If you plan to build a new home or make some major structural changes to your existing home, you may want to apply for a construction loan.
A construction loan is a short-term home loan designed to cover the costs of a major renovation or new build. The loan is interest-only during the construction period that typically lasts for about 12 months to two years. During this time, the loan is drawn down progressively, and you are only charged interest on the drawn down amount instead of the entire principal.
How much can I borrow?
The size of your loan depends on your income and existing liabilities and whether you are constructing as an owner-builder or hiring a registered builder for the job.
If you plan to build your home as an owner-builder, you are assuming the responsibilities of a registered builder, and you are responsible for every single detail. Unless you are licensed or have past building experience, lenders are likely to see you as more of a risk. As a result, you’ll require a larger deposit to qualify for a loan. Generally, you can borrow up to 60% of the project cost as an owner-builder. However, if you hire a registered builder for the job, you could get approved for up to 95% of the project cost.
How do construction loans work?
A construction loan is advanced to you in stages as the renovation or rebuild progresses. Most lenders pay the bills directly to your builder at the completion of different stages in the construction process.
There are generally five stages of construction identified for the purpose of a construction loan. These are: slab, framework, lock-up (sealing the structure with doors and windows), second fit-out (plastering and sealing), and completion.
At the completion of each stage, the builder generally issues you an invoice. Once you are happy with the work, you can sign the invoice and send it to your lender to have the funds released to the builder directly.
The biggest advantage of a construction loan is that it is released in stages throughout the construction period, and you are only charged interest on the amount that’s been paid. For instance, if your loan is for $300,000 and the bill at the first stage is $50,000, you’ll only pay interest on $50,000 and not the entire $300,000.
Once the construction process is complete, the lender releases the builder’s final payment, and your loan converts to a standard variable-rate home loan with principal and interest payments.
What are the pros and cons of a construction loan?
Construction loans offer progressive drawdowns linked to the various construction stages. This helps you save money in interest as you are only charged for the amount paid to the builder.
Construction loans could also help you manage your cash flow better by only charging you interest during construction. However, you may find yourself paying a little more over the life of the loan compared to a standard mortgage, as you are on interest-only repayments for the construction period.
Overall, a construction loan is a good option for financing your building project, but most good things come with a fee. In addition to the usual establishment fees, some lenders may charge you a small drawing fee for each payment under the loan. It’s also difficult to change the building contract once you have a construction loan in place. If you need to make even a minor amendment to the building contract, the lender may want to reassess your loan all over again, and your build is likely to encounter delays.
A little help can go a long way
A construction loan is a different product than a standard home loan. The building process is typically considered complicated, and lenders want to assess their risk carefully while advancing a construction loan. As a result, you are required to provide additional paperwork apart from the standard documentation needed for an owner-occupier home loan. For instance, your lender will want details of your building plans. This includes approved council plans, builders insurance, and a copy of your building contract if you are working with a builder. Depending on the lender, some other documents may also be required.
While nothing is stopping you from doing it alone, having a mortgage broker by your side can make the process of applying for a construction loan much simpler. A good broker will help you shop around and find a lender with a competitive rate. They will assist you in comparing different loan deals to find one that fits your specific situation. You can also expect help in preparing your paperwork and lodging your application, minimising any delays or rejections due to missing details or incorrect paperwork.
