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How do land and construction loans work?

How do land and construction loans work?

If you decide to buy land on which to construct a new house, there are a few ways you can raise the funds you need. While there’s a chance that a standard home loan may work for you, it’s more likely that you’ll want a special kind of loan for your land and house.

Can I get a standard home loan?

It's not always possible to use a standard home loan to buy land and build a house. This is because the value of the property won't be certain until construction is complete, making it unsuitable as security for your loan. 

However, if you already own another property, or the land where you plan to build, you may be able to use your equity to apply for a standard home loan to pay for the construction of your new house. 

Of course, there are also specialist loans available for borrowers in your situation. 

Land and construction loans

If you plan to construct right away, you may want a combined house and land loan. This is made up of two components - a land loan and a construction loan.

Alternatively, if you intend to buy the land and construct the house later, you could take separate land and construction loans. 

Turnkey and house and land packages

There are two ways in which package deals can be structured: 

  1. A turnkey package, where the builder takes care of everything related to the land and construction. When the house is completed, you can move right in. The total cost is finalised at the start of the project. You pay a deposit to the builder, usually about 10 per cent. The balance of 90 per cent is released by the bank when your home is completed and a code compliance certificate has been issued. 
  2. A house and land package, where you buy the land and can get your house built whenever you decide you’re ready. You can usually borrow up to 95 per cent of the value of the land, but your lender may require you to purchase Lenders Mortgage Insurance (LMI) if your deposit is less than 20 per cent. Your borrowings will consist of a land loan and a construction loan. 

Land loans

Land loans help you to buy land on which you intend to build your house. These are particularly helpful if you wish to acquire the land now and construct your home later.

When considering a land loan vs a construction loan, bear in mind that land loans do not specify a time limit within which you need to construct your house. 

Construction loans

When you take out a construction loan, the lender approves the amount that your house will cost to build, but you ‘draw down’ the loan in stages. You pay your builder as the construction progresses, and you’ll be charged interest on what you've drawn, not on the entire amount. The bank may require you to complete the construction within a specific period.

The amount you can borrow on a land and construction loan depends on the bank's estimated ‘on-completion value’ of your future home. The construction cost quoted by the builder is also taken into account when calculating your borrowing limit. 

Most construction loans are interest-only, meaning that you pay only interest until your house is completed. After that, you start to repay the principal and interest. Not needing to repay the principal while your home is being built eases your cash flow situation during that period. 

While construction is underway, your lender may want to inspect the progress to see that it matches the terms of the building contract. 

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This article was reviewed by Personal Finance Editor Mark Bristow before it was published as part of RateCity's Fact Check process.

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