What is a Construction Loan?

 

A construction loan is a specific type of mortgage designed for people wanting to build a new home. Depending on the way a construction loan is set up, you may be able to purchase your vacant block of land first and then arrange to build on the land within a specified timeframe.

Construction-loanConstruction loans aren’t set up in quite the same way as a regular mortgage in the beginning. Instead, the lender considers the total amount you need to borrow in order to pay your builder, and then breaks down the full amount into separate payments called progress draws. These are percentages of the total building contract amount paid out of your mortgage funds to the builder throughout the construction process.

While progress draws are being made, the majority of lenders will only expect you to pay the interest due on the amounts that have been drawn. Your full principal and interest payments won’t begin until after the handover has taken place and you have received the keys to your new home, meaning you save on interest during the construction process.

Who Needs a Construction Loan?

A construction loan is set up differently to a regular mortgage to include progress payments in stages to your builder, so if you intend to build a new home you do need one.

It’s important to do some homework to be sure you have the right construction loan to suit your needs. Some lenders will charge a slightly higher interest rate during the construction period, this is often referred to as interest rate loading, so be sure you understand how much you’ll be paying. You may also want the ability to make extra payments on your mortgage during the construction stage, so check that you can do this.

Construction loans are suitable for any borrower intending to build a new home on a vacant block of land. This includes buying a house and land package from a licensed builder, or conducting major renovations to an existing home, such as adding new rooms.

Property developers for small scale developments may also use construction loans, but these might only be available if you’re building under a certain number of properties. If you’re building a larger amount of properties (usually over four) most lenders will consider this to be larger-scale development, which will require commercial finance instead.

The Construction Process

Obtaining an appropriate construction home loan can be complicated, but it’s worth the trouble once it all comes together, especially if you are your own main contractor and your home loan is unconventional. In order to help make the process a little more understandable, the following points outline what has to take place:

  • The first step is to have your plans professionally drawn up and fully costed before placing them before your lender for home loan approval. The lender will then have an appraiser complete a preliminary assessment of the assumed value once the house is completed from the plans you have submitted. Construction home loans require management by a local financier until the home is completed, as such loans are not sold on the secondary mortgage market. After completion you can arrange to have the construction home loan converted to a regular home loan.
  • Your next step is to either make a deposit to the lender or purchase the lot of land that the home is to be built on. This acts as sufficient security for the loan at this stage. The lender needs to see the level of your commitment to the project and your equity in the project right from the beginning, goes a long way in demonstrating this commitment. It will help if you own your building block outright.
  • Before committing yourself to the first offer made it will pay you to look around to see what other lenders are offering so that you can make a proper comparison. Construction home loan interest rates vary much more than rates on regular home loans, and can sometimes be as much a three percentage points higher.
  • You must take out a builders risk insurance policy to protect yourself and your lender against any storm or fire damage. This is important even if your have contracted the work out to a builder who has commercial liability insurance. You will need the extra cover to fully protect your own interests and that of your lender for total coverage.
  • Some construction loans are designed to finance the building of your home only, while others are framed around that of a more traditional mortgage. While the basic elements of the loan are much like any other, you may find it necessary to have the loan changed to a more traditional home loan after the construction is completed in order to get the range of benefits that a more flexible mortgage offers.

With most licensed builders, the contract should include a section outlining exactly what stages will be completed throughout the construction of your home. In most cases, there will be five stages:

  1. Foundations/footings: this stage also includes site cutting and preparation, as well as running initial plumbing into trenches before pouring the slab;
  2. Frame and brickwork: this stage includes the first fix framing of the house, plus brickwork and roofing, as well as first fix electrical fittings;
  3. Lock Up: this stage includes installing windows and doors, along with gyprock or wall linings and any insulation if it’s required. The home is lockable at this point;
  4. Second Fix: the second fix stage sees the gyprock flushed ready for painting, kitchen benches and cupboards installed, tiling started to wet areas, second fix plumbing done, second fix electrical work done, architraves, skirtings and cornices fitted and guttering, downpipes and eaves completed;
  5. Practical completion: the final stage of construction usually includes painting the home inside and out and adding those finishing touches, such as installing shower screens and walk-in robes.

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Inside your building contract, you should see an itemised listing for each stage noted above. Alongside each stage will be a percentage number. This indicates what percentage of the total building contract amount is due to be paid to the builder after completion of each stage.

For example:

  • Foundations/slab = 25%
  • First Fix = 20%
  • Lock Up/Internal Linings = 15%
  • Second Fix = 25%
  • Practical Completion = 15%

Your bank will work out exactly how much your building contract comes to, minus any deposits you’ve already paid to the builder and then divide up your total home loan amount to pay to the builder accordingly after each stage is complete.

Things to Consider about Constructions Loans?

Because of the inherent risks involved for the lender, construction home loans are normally only offered to borrowers who have very good credit histories. The eligibility criteria is much more stringent for construction home loan applicants than it is for borrowers applying for a more traditional home loan. The initial down payment that is required is usually quite significant, especially if the building lot is not of great value without a building on it, most lenders will want at least 20 percent of the total cost put down as a deposit.

Considerable costs are involved in building your own home. Where you can purchase an existing home with a comparatively small amount of money needed for a deposit, this is not the case with a construction home loan, as many lenders require you to own your own building lot outright as well as a 20 percent down payment. This is a factor that prevents many from borrowing a construction home loan in order to build themselves but prefer to buy an existing property with a more traditional mortgage that is easier to obtain.

But it’s not just the cost you need to consider before choosing to build. There are a number of other factors you should be aware of when choosing a construction home loan:

Do I need to buy a house and land package to get a construction loan?

You don’t technically need to buy a house and land package from one builder or developer to get a construction loan. You may have already purchased a vacant block of land earlier using a regular home loan. It’s only when you sign a building contract with your licensed builder that you’ll need a construction loan. Keep in mind that you will end up with two separate mortgages this way.

Do I have to use a licensed builder to construct my home?

The vast majority of banks and lenders will prefer that you choose a licensed builder to construct your home before they extend a construction loan for you. However, there are some lenders that will allow you to build your own home as an owner builder. This is ideal if you’re a qualified tradesperson or if you have a building license of your own, but an owner builder loan isn’t suited to the faint of heart.

What clauses are involved with a construction loan?

In some states of Australia you are able to include a finance clause when you sign your contract for your vacant block of land. This type of clause is quite common when purchasing vacant land or even an established home via private treaty sale (not at auction), where you’re able to insert a clause that says “Subject to Finance”.

You may also be able to include specific dates and other information that is relevant to your clause. For example, you can add that your clause is subject to finance being approved with a specific lender for no more than a specific interest rate and that your finance approval needs to be received by a specific date. Remember, in this instance your finance approval is the full formal approval, or unconditional approval from your bank.

The primary reason for adding specific information like this is to protect you against having to accept finance that isn’t right for you or your situation. So, if you’ve already received a pre-approval from your lender and you already know your interest rate, you can enter this information into your clause.

If your finance clause is written this way, you have some backup in case your bank suddenly decides to decline your mortgage application at the last minute. After all, if you’ve simply written “Subject to Finance” and nothing else, you might suddenly find that the vendor can insist you accept any finance at ridiculous interest rates just to comply with the contract. Of course, this is very rare – but it’s not unheard of.

The ability to include a finance clause like this gives you several benefits:

  • It helps to protect you against being forced to take out finance that isn’t suited to you;
  • It allows you to get out of your contractual obligation if your finance application doesn’t get approved for whatever reason;
  • It removes your block of land from the market while the agent waits to hear about your finance approval;
  • It gives you time to obtain your finance.

What if a building contract changes?

There are some cases where a lender will make a construction loan more expensive. This is due to how the contract price might go up after you get an amendment on your home prepared. This can especially be difficult because the builder will end up having to reassess the value of the loan from the top. However, you can do a few things in order to keep this from being a problem down the road.

  • Get your building contract completed and finalised before sending it to your lender.
  • Pay for any new changes to your construction with your own money. You could also ask your builder to reimburse you in the event that you got any discounts out of something.
  • Consult your lender if the changes are massive. You might need to wait a month for the lender to review the loan again.
  • Be sure to simplify your changes. This is so it will be easier for the bank to make changes and to keep from being delayed in the process.

How to choose a construction loan

Just like a regular home loan, the way you compare a construction loan will have an impact on the value you get out of it. Here’s what you should compare:

  • Interest rates. You’ll only be paying interest during the construction period, meaning the interest rate you receive will have an important bearing on the size of your repayments. Keep in mind that the advertised rate doesn’t take into account the fees you will pay for the loan, so be sure to also look at the comparison rate, as this will have an impact on this.
  • Fees. Some construction loans will have extra fees which they’ll charge to cover the costs of having a valuer check your property after each stage of the building is completed. Some home loans can also charge extra administration fees for construction loans, so you may need to factor this into the total cost of your home loan. These fees are in addition to regular upfront fees such as application costs, valuation fees and more.
  • Features. During the construction phase most features of your home loan will be unavailable, such as redraw and the ability to make additional repayments (this of course will depend on the particular loan), but it still pays to know what features you’ll be able to use once the construction phase ends. Find out what features you want out of your home loan and then ensure you search for these during your comparison.
  • Construction terms. You’ll want to confirm what construction terms your loan will offer, including how long you can build for using the loan and the process for drawing down and accessing funds.