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What are construction home loans?

What are construction home loans?

The Great Australian Dream may be to purchase a property of your own, but many Australians would rather build the home of their dreams. This can be a costly and time-consuming process – and this is where a construction home loan comes in.

A construction home loan is a short-term, variable home loan designed so that you receive a set amount at each stage of building or renovation. Repayments are typically interest-only during the construction period.

Unlike a traditional home loan in which a bank lends you the principal amount minus the deposit you’ve saved, a construction home loan helps borrowers to pay for the build itself. Once the home has been constructed, the loan will generally revert into a traditional home loan, with ongoing mortgage repayments and interest charges.

In many circumstances a construction loan will assist you to buy land, build a residential dwelling on purchased land or finalise purchasing the land and conduct any construction or renovation work necessary.

The payment stages of a construction loan

Construction loans are only temporary, helping to pay the builder in five stages: slab, frame, lock-up, fit-out and completion.

The builder will produce an invoice at each stage of construction. You will then need to complete and sign a drawdown request form from your lender, submitting this to the lender with the invoice from the builder for the release of funds. The lender may follow this up with a valuation of the site to ensure that this stage has been completed before releasing the funds.

This process is then repeated throughout each five stages. Once the construction is complete the loan will revert to a permanent mortgage (principal and interest).

StageAboutFunds released (approximate)
SLABConcrete slab is laid.15-20%
FRAMECompletion of exterior frames and brickwork, as well as installation of plumbing, electrical and gutters.20%
LOCK-UPInstallation of remaining windows, doors, external walls and roofing.20%
FIT-OUTInternal fittings and fixtures completed, including lights, carpets, kitchen units etc.30%
COMPLETIONFinalising the build, including fencing, site clean-up, painting etc. The home loan lender may inspect the property for final valuation.10-15%

By allocating small amounts of money over the construction period to the contractor this ensures the builder isn’t being paid for work that has not yet been finished. These measures are designed to protect the borrower from any financial loss during the construction period.

The benefits and risks of a construction loan

Before you sign on the dotted line to bring your dream home build into reality, it’s worth weighing up the advantages and potential risks of a construction loan.

Firstly, construction home loans offer interest-only payments during the building process. This can make your ongoing repayments during this period significantly lower than if you were to purchase an existing dwelling and make principal and interest repayments.

This can be appealing for investors hoping to earn the greatest return on their investment, or owner-occupiers trying to manage their budget. However, it’s worth keeping in mind that you won’t be paying off any principal owing during this period, so you aren’t actually reducing your final mortgage bill.

Construction loans may come with a higher number of fees, including drawing fees for each progress payment. You may also be charged establishment fees and other ongoing fees, so be sure to read the PDS before signing on the dotted line.

It’s also worth noting that construction loans are typically on variable interest rates. It may be worth researching the current interest rate market to see if this is the best suit for your budget and financial situation. If, for example, interest rates were forecast to rise during your construction process, your interest-only repayments would rise as well.

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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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