What is a construction loan?

A construction loan is a specialised lending option available for new home builds and renovations.

Unlike regular home loans where you typically receive a lump sum of the loan amount at settlement, construction loans are paid via progressive drawdowns/progress payments, where a portion of your loan funds are released at each stage of construction.

A construction loan will usually be interest only over the first 12 months and then revert to a standard principal and interest loan.

Some lenders will ask for the builders’ invoice at each stage of construction and send a valuer to check the work has been completed to an acceptable standard, before releasing the next payment. As the loan is being progressively drawn down, interest and repayments are calculated based only on the funds used. For example, if by the third progressive payment, only $150,000 has been drawn down on a $300,000 loan, interest would only be charged on $150,000.

Pros

  • Protection – By making progress payments, you can make sure that builders and contractors aren’t being paid for work that hasn’t been completed yet.
  • Less Interest – You only pay interest on the amount drawn down and not the fully approved loan amount, saving you money during the construction period.
  • Lower Repayments – Your loan is interest only during the construction period, helping your cash flow while the work is being carried out.

Cons

  • Paperwork & Hassle – The lender will want to see council approved building plans and a fixed price building contract before they approve a loan. Most lenders will complete a valuation of the property before the build / renovation. Some lenders will also require further inspections and valuations throughout the project.
  • Deposit – Most lenders will want a large deposit to be made before they approve the loan.
  • Availability of Funds – You may only be able to pay contractors once the lender is satisfied with the progress.
  • Higher Interest Rate – The interest rate can be higher than the rate charged on a home loan.
  • Fees – Some lenders charge a fee for every progressive drawdown.
  • Cost Overruns – if the building expenses exceed the planned progressive payments agreed to at the start of your loan, the lender may not provide additional funding & you may need to cover the extra cost yourself.

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