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What is a construction loan?

A construction loan is a short-term variable home loan specifically for covering the costs of a major renovation or knocking down an existing property and building a new home. Construction loans are short-term and are interest-only during the construction period to reduce your repayments during that time.

Most construction loans pay the bills directly to your builder in stages as the renovation or rebuild progresses. The advantage over a regular home loan is you only pay interest on the amount you draw down or pay to the builder, not on the entire loan amount. And let’s face it, building is stressful enough without added cashflow issues so the less you’re paying during the construction process, the better.

How does a construction loan compare to other mortgage offers?

Construction loans come with flexibility that regular home loans don’t have. But they also come with some added fees and require extra paperwork. And since you’re on interest only repayments during the construction, it could cost you a little more over the life of the loan.

If you’ve saved up some money in your offset account or redraw and intend to put that towards your reno or rebuild, you’ll have to spend that first before drawing down on your construction loan. Once you’ve had your loan approved, you’ll need to get started within six months of the date on your loan contract (some banks have stretched that out to 12 months because of Covid 19). Then you’ll pay your builder a deposit – typically around 5 per cent of the contract price.

The construction loan will be split into stages. That means you draw down your loan in various stages of the build, also known as progress payments. You'll pay interest-only repayments on the amount that has been paid to the builder. So unlike a typical home loan, you’re not making interest repayments on the full amount upfront – only on the drawdown amount. If you need to rent elsewhere while building, this feature can help with cashflow.

Some lenders charge a drawing fee for each progress payment. Those fees are added to your loan total. You’ll still have set up costs and establishment fees, so make sure you check the comparison rate which takes these costs into account, and carefully read the product disclosure statement. Construction loans typically require you to be on a variable interest rate. While you might not get the super competitive fixed rate loans under 2 per cent, you also won’t pay the premium that interest-only loans usually attract and the loan term is short.

At the end of construction, your contract will convert to a standard home loan.

What are owner-builder mortgages?

Owner-builder mortgages are for people who plan to build their own home. If you are a licensed builder, you should be able to borrow up to 95 per cent of the project cost. If you fancy yourself as a DIY aficionado, you’ll be limited to borrowing 60 per cent of the project cost.

As an owner-builder, you assume all the responsibilities of a registered builder. That means you organise and co-ordinate the trades, you look after the budget and have responsibility for every last detail of the project. If you’re not 100 per cent confident in your expertise or experience, you might want to reconsider.

A few banks and building societies have withdrawn this type of home loan option. Owner-builder mortgages are seen as riskier than construction loans where a licensed builder is in charge. You’ll need extra paperwork and a larger deposit or guarantor before you head down this path.

What are the risks of construction loans?

Construction loans typically require a fixed price contract from a builder before your lender will give the green light. But the cost difference between a fixed price contract and a cost-plus arrangement can be as much as 20 per cent to allow for any unknowns once the build commences.

The biggest risk for borrowers is the performance of the builder. Once you have a fixed price contract and a construction loan based on that contract, you are locked into that builder.

The builder may also have clauses in the contract for delays based on weather or other factors. Check all disclaimers or you could find yourself in a precarious financial situation if the build runs late.

How do construction loans work?

Construction loans cover only the period of time you’re building and once the home is complete, your loan converts to a regular home loan.

The loan is split into stages or progress payments to coincide with the different stages of construction.

Most have five stages: slab, frame, lock-up, fit-out and completion. At each of the stages, the builder will issue you an invoice. If you’re happy with the work, you sign it and send it on to your bank or broker to release the funds to the builder. The good news is you only pay interest on the amount that’s been paid. For example, if your loan is for $500,000 and the bill for your first stage is $100,000, you will only pay interest on $100,000 not the full value of the loan. If, however, you’re pouring some of your savings into the construction, you will need to use that money up first before drawing on your construction loan.

As with any loan contract, read the fine print for fees and charges. A construction loan has the usual establishment fees but some will charge a drawing fee for each progress payment. It might only be $75 but five lots quickly adds up to an extra $375 that will be added to your loan total. Lenders will put you on a variable rate rather than a fixed rate.

At the end of the construction process, your contract will convert to a standard home loan where you choose whether to pay principal and interest or interest-only loan repayments.

Payment stages in a construction loan

  1. SLAB: The concrete slab is laid. Approximately 15-20 per cent of funds paid (may include a 5 per cent deposit to the builder)
  2. FRAME: Exterior frames are built and brickwork is completed. Electrical, plumbing, gutters and insulation are installed. Approximately 20 per cent of funds paid
  3. LOCK-UP: Remaining windows, doors, external walls and roofing are installed so the home can be effectively locked up. Approximately 20 per cent of funds paid
  4. FIT-OUT: Internal fittings and fixtures are completed at this stage including lights, powerpoints and other plumbing. Approximately 30 per cent of funds paid
  5. COMPLETION: When contracted items are finalised including fencing and site clean-up, final detailing and painting works are carried out. The bank or their valuer will inspect at this stage before making the final progress payment of approximately 10 per cent of funds.

Do you need land for a new construction loan?

You can buy a house and land package and the first drawdown will be for the land and subsequent progress payments would cover each stage of the construction. Or you can use a construction loan to build or renovate a home on land you already own.

Is a construction loan just a big personal loan?

No. It might be “big” but a construction loan is quite different to a personal loan. The term of a personal loan usually ranges from one to seven years while the term of a construction loan will last for the duration of the build – typically around a year.

The interest on a personal loan can be fixed or variable; on a construction loan, it’s usually variable. The interest rates on personal loans can be three times higher than for construction loans.

A personal loan can be used to fund all sorts of purchases from cars to holidays and small renovations but a construction loan can only be used for a single purpose.

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What do you need for a construction loan?

Like any other home loan, you’ll need to meet the lending criteria, show that you have a good credit rating and ability to service the loan. You'll need personal identification documents, pay slips, bank statements and a detailed list of all your expenses and liabilities before you can apply.

To be eligible for a construction home loan, you’ll need to add a few more documents. You’ll require council approved plans and specifications, a signed and dated building contract including a building plan and a schedule of payments, variations and quotes if applicable as well as a quantity surveyor report for building contracts in excess of $1 million.

Before settlement, you’ll need to provide Builders’ Risk Insurance and a copy of your builder’s Public Liability Insurance.

To qualify for a construction loan, you need to be building or renovating your own home or an investment property that you intend to keep and not sell immediately.

Can a first-home buyer get a construction loan?

Yes, first home buyers can take out a construction loan but there may be a few hurdles to overcome. For example, you may want a licensed builder on board, as trying to DIY may raise flags with your lender. Banks may also want to see that you have some savings in case the project runs over budget. 

If you don’t have a 20 per cent deposit, you’ll need to pay for lenders mortgage insurance, which covers your lender (not you) in case you default on your repayments. Alternatively, make sure you’re on excellent terms with a family member who could serve as a guarantor. With government support including Canberra’s 5 per cent deposit scheme, you could finally take that step towards home ownership.  

Can you refinance a construction loan?

Refinancing a construction loan mid-construction can be complex and may be impractical. However, as soon as construction is complete, your loan reverts to a typical home loan.

How soon can you refinance? Your lender or broker will conduct a review at the end of construction and you can look at refinancing your regular home loan then. Chances are that your renovation has added significant value to your home, giving you some equity to play with.

Can a broker help you with a construction loan?

How do you apply for a construction loan?

Applying for a construction loan is the same as applying for any home loan with some added paperwork and a licensed builder on board.

You’ll need to fill out a home loan application form complete with payslips, a list of yearly expenses and personal identification documents. You may want to have a 20 per cent deposit saved up so you have a loan to value ratio (LVR) of 80 per cent, as well as a good credit rating. You’ll also need a fixed price contract from a builder and documents showing you have council approved plans.

Your lender will carry out a valuation based on what the home would be worth once completed. This will help determine how much you can borrow.

What documents do you need for a construction loan?

  • A completed home loan application form with income and employment history and expenses
  • Council approved plans and specifications
  • A signed and dated building contract including a detailed schedule of payments
  • Variations and quotes
  • A quantity surveyor report for building contracts in excess of $1 million
  • Builders’ Risk Insurance and a copy of your builder’s Public Liability Insurance  

Can you use a guarantor for a construction loan?

Yes you can. If you only have a small deposit with an ambitious build in mind, a guarantor could help you secure the funds you need. A guarantor can also help you avoid lenders mortgage insurance if you don’t have a 20 per cent deposit when your construction loan reverts to a standard home loan.

What is a construction loan?

A construction loan is loan taken out for the purpose of building or substantially renovating a residential property. Under this type of loan, the funds are released in stages when certain milestones in the construction process are reached. Once the building is complete, the loan will revert to a standard principal and interest mortgage.

What is a building in course of erection loan?

Also known as a construction home loan, a building in course of erection (BICOE) loan loan allows you to draw down funds as a building project advances in order to pay the builders. This option is available on selected variable rate loans.

How do I apply for a home improvement loan?

When you want to renovate your home, you may need to take out a loan to cover the costs. You could apply for a home improvement loan, which is a personal loan that you use to cover the costs of your home renovations. There is no difference between applying for this type of home improvement loan and applying for a standard personal loan. It would be best to check and compare the features, fees and details of the loan before applying. 

Besides taking out a home improvement loan, you could also:

  1. Use the equity in your house: Equity is the difference between your property’s value and the amount you still owe on your home loan. You may be able to access this equity by refinancing your home loan and then using it to finance your home improvement.  Speak with your lender or a mortgage broker about accessing your equity.
  2. Utilise the redraw facility of your home loan: Check whether the existing home loan has a redraw facility. A redraw facility allows you to access additional funds you’ve repaid into your home loan. Some lenders offer this on variable rate home loans but not on fixed. If this option is available to you, contact your lender to discuss how to access it.
  3. Apply for a construction loan: A construction loan is typically used when constructing a new property but can also be used as a home renovation loan. You may find that a construction loan is a suitable option as it enables you to draw funds as your renovation project progresses. You can compare construction home loans online or speak to a mortgage broker about taking out such a loan.
  4. Look into government grants: Check whether there are any government grants offered when you need the funds and whether you qualify. Initiatives like the HomeBuilder Grant were offered by the Federal Government for a limited period until April 2021. They could help fund your renovations either in full or just partially.  

How much deposit do I need for a home loan from ANZ?

Like other mortgage lenders, ANZ often prefers a home loan deposit of 20 per cent or more of the property value when you’re applying for a home loan. It may be possible to get a home loan with a smaller deposit of 10 per cent or even 5 per cent, but there are a few reasons to consider saving a larger deposit if possible:

  • A larger deposit tells a lender that you’re a great saver, which could help increase the chances of your home loan application getting approved.
  • The more money you pay as a deposit, the less you’ll have to borrow in your home loan. This could mean paying off your loan sooner, and being charged less total interest.
  • If your deposit is less than 20 per cent of the property value, you might incur additional costs, such as Lenders Mortgage Insurance (LMI).

Can I take a personal loan after a home loan?

Are you struggling to pay the deposit for your dream home? A personal loan can help you pay the deposit. The question that may arise in your mind is can I take a home loan after a personal loan, or can you take a personal loan at the same time as a home loan, as it is. The answer is that, yes, provided you can meet the general eligibility criteria for both a personal loan and a home loan, your application should be approved. Those eligibility criteria may include:

  • Higher-income to show repayment capability for both the loans
  • Clear credit history with no delays in bill payments or defaults on debts
  • Zero or minimal current outstanding debt
  • Some amount of savings
  • Proven rent history will be positively perceived by the lenders

A personal loan after or during a home loan may impact serviceability, however, as the numbers can seriously add up. Every loan you avail of increases your monthly installments and the amount you use to repay the personal loan will be considered to lower the money available for the repayment of your home loan.

As to whether you can get a personal loan after your home loan, the answer is a very likely "yes", though it does come with a caveat: as long as you can show sufficient income to repay both the loans on time, you should be able to get that personal loan approved. A personal loan can also help to improve your credit score showing financial discipline and responsibility, which may benefit you with more favorable terms for your home loan.

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