How do construction loans work? Your guide to financing a new build

Building a home from the ground up is an exciting journey, but it requires a unique type of financing known as a construction loan. Unlike standard home loans, construction loans are structured specifically for financing the costs of building a new home or major renovation. This guide breaks down what construction loans are, how they work, and what to expect at each stage of the process.

What is a construction loan?

A construction loan is a short-term, variable-rate loan designed to cover the costs of building or renovating a property. Unlike a standard home loan, a construction loan is disbursed in instalments, also called drawdowns or progress payments, instead of providing the entire loan amount upfront. These drawdowns align with each stage of construction, so funds are only released as needed.

• How construction loans differ from home loans

  • With a typical home loan, the full loan amount is disbursed at once, and repayments start immediately. With a construction loan, the loan is drawn down in stages, allowing borrowers to pay interest only on the amount they’ve used rather than the full loan amount.

How do construction loans work?

Construction loans have a unique structure, disbursing funds at key construction stages, allowing borrowers to pay interest only on the drawn-down amount. Here’s how the process typically works:

• Pre-approval and land purchase

  • Before construction can begin, the borrower usually needs to secure pre-approval for a construction loan. This includes providing the lender with building plans, permits, and a construction contract detailing costs. If you’re buying land separately, you may need a land loan or use the construction loan to cover the land purchase.

• Drawdowns and construction stages

  • As your builder completes each stage, funds are released by the lender as drawdowns. The five main stages of construction (and corresponding drawdowns) are:

1. Slab or Base Stage – Laying the foundation and initial plumbing.
2. Frame Stage – Erecting the frame for walls, windows, and roofing.
3. Lockup Stage – Installing walls, roofing, and securing the structure.
4. Fit-Out or Fixing Stage – Interior work, including plumbing, electrical, and fixtures.
5. Completion Stage – Final touches, inspections, and approvals.

• Interest-only payments during construction

  • During the construction phase, you typically only pay interest on the portion of the loan drawn down, rather than on the entire loan amount. This can make repayments more manageable while construction is underway. Once construction is complete, the loan generally converts to a standard principal-and-interest mortgage.

How much can you borrow with a construction loan?

The amount you can borrow depends on factors like the total cost of construction, the value of the land (if applicable), and your financial profile. Lenders typically use the Loan-to-Value Ratio (LVR) to determine how much they’re willing to lend. For construction loans, an LVR of up to 90% may be available, though this can vary by lender.

• Providing a fixed-price building contract

  • Most lenders will require a fixed-price contract from your builder, outlining the costs for each stage. This ensures there’s a clear budget for the construction, reducing the risk of unexpected expenses and delays.

• Valuation and deposit requirements

  • Lenders will usually conduct a valuation of the completed property to confirm the expected value aligns with the loan amount. Depending on the lender and the LVR, a deposit of 10-20% of the total project cost is often required.

Pros and cons of construction loans

Construction loans can be ideal for financing a new build or significant renovation, but they have both advantages and potential drawbacks.

• Pros of construction loans

  • Interest Savings: Interest is only charged on the drawn-down amount, reducing the cost during construction.
  • Flexible Drawdowns: Funds are released as needed, providing better cash flow management.
  • Customisation: Suitable for new builds or large-scale renovations, giving you control over the project.

• Cons of construction loans

  • Higher Interest Rates: Construction loans typically have slightly higher variable rates than standard home loans.
  • Progress Inspections: Each stage requires an inspection before funds are released, which can create delays if construction is not on schedule.
  • Documentation Requirements: Construction loans require detailed building plans, permits, and contracts, adding to the approval process.

How to apply for a construction loan with Australian Finance Hub

When you’re ready to apply for a construction loan, Australian Finance Hub can help make the process straightforward and transparent. Here’s what to expect in our step-by-step approach:

1. Talk with expert mortgage brokers
   

   Our experienced mortgage brokers will meet with you to understand your financial position and goals. We’ll search through hundreds of loan options to find the one that suits your needs, calculate your borrowing power, work out repayments, and answer any questions. We’ll also provide a checklist of documents needed to proceed to the next stage.

2. Loan preparation & processing

   Once we’ve created a tailored loan solution, we begin preparing the application, sending you a proposed loan breakdown with details on rates, repayments, and any fees. We’ll collect any missing documents needed, then send the final documentation for your review and signature.

3. Conditional or pre-approval
   

   Your broker will work closely with the lender to secure conditional approval, keeping you informed every step of the way. Conditional approval is valid for three months. If you’re still searching for the right property, we can arrange a pre-approval to give you peace of mind.

4. Unconditional approval and contract signing
   

   Once credit checks, valuations, and other criteria are met, the lender will issue unconditional approval, confirming your loan amount. This is the point where you can confidently make your purchase or finalise construction plans.

5. Loan settlement
   

   The final stage is settlement, the process of legally transferring ownership. For property purchases, your solicitor or conveyancer will work with the lender to ensure all settlement requirements are met by the settlement date. For refinances, our team coordinates the transfer directly with your previous lender.

6. Ongoing support
   

   Our relationship with you doesn’t end at settlement. We’ll continue to review your loan every six months to make sure you’re always on the best rate available, offering ongoing support with financial updates and tips to help you stay on track.

   Converting your construction loan to a home loan

Once construction is complete, your construction loan will typically convert into a standard home loan. This means:

• Switching to principal and interest payments

  • Instead of paying interest only, you’ll begin repaying both principal and interest. This increases the repayment amount but allows you to start reducing the loan balance.

• Potentially refinancing

  • You may have the option to refinance your loan with another lender if better rates or terms are available. Refinancing could save money or provide additional features as you settle into your new home.

Frequently asked questions

• • Can I use a construction loan for renovations?

  • Yes, construction loans can be used for significant renovations as long as you meet the lender’s requirements and provide a fixed-price contract.

• What happens if construction goes over budget?

  • Lenders base the loan amount on a fixed-price contract, so any over-budget costs may need to be covered out of pocket. It’s wise to keep a contingency fund for unexpected expenses.

• How long do I have to complete the construction?

  • Most lenders require construction to be completed within 12-24 months. If delays arise, you may need to request an extension, but this is subject to the lender’s approval.

A construction loan is a powerful tool for financing a new build or major renovation, offering flexibility and cost management during the construction process. By understanding how these loans work, from drawdowns to interest payments, you can navigate your home-building journey with greater confidence. Contact Australian Finance Hub today, and let our expert mortgage brokers guide you from planning to completion, making your dream home a reality.