What is a construction loan?
A construction loan is designed for borrowers building a home or investment property. It can also be used for major renovations or structural works on an existing property. You may need a construction loan when you purchase:
- Land you plan to build on
- A house and land package
- An off-the-plan property
- A property intended for demolition or major renovations
How do construction loans work?
A construction loan works similarly to a standard home loan, but with some key differences.
- Unlike a traditional home loan, which provides a lump sum of funds, a building loan is paid out in stages throughout the construction process. This is called a ‘progressive drawdown’.
- Each progress payment is set as a percentage of the total building contract amount.
- You’ll only pay interest on the amount you’ve drawn down.
- It's often paired with a land loan to finance the land purchase, with the construction mortgage typically following afterwards.
- As part of the application process, your lender will ask for your builder's fixed-price quote detailing the total cost of the project broken down into each stage of construction.
- The lender will conduct an 'as if complete' valuation to estimate the market value of the land and proposed build before approving your loan.
- You can make interest-only repayments on the loan while construction is in progress.
- Once construction is complete and you receive a certificate of occupancy, your construction will be converted into a standard owner-occupier home loan (or an investment property loan if you’re renting the home out).
- Like a regular home loan, aim for a 20% deposit (i.e. a loan-to-value ratio below 80%) before applying. Approval with a 5% deposit of the build’s value is possible but may come with extra fees like LMI and higher interest rates.
- Building loans come with a specific timeframe. Most lenders allow six months to draw on the loan and up to 24 months to complete the construction of the property.
Construction home loan interest rates & fees
Construction loans generally have higher interest rates than standard home loans because they’re secured by an asset that doesn't exist yet, therefore presenting more risk for lenders.
Construction loans not only have higher interest rates but may also incur extra fees. Some lenders will charge a drawdown fee each time you make a progress payment during construction and separate valuation fees when checking construction stages. These fees are usually added to your loan amount.
The average loan for new construction is $594,377 in Australia, while the average new loan for an existing property is $632,014, according to the ABS. Construction loans make up 9% of all residential loans, mortgages for existing properties make up 73%, and the rest are for newly-built properties or loans for major renovations.
Construction loan versus standard home loan
Purpose | |
Construction loan | Finance the construction of a new home or major renovation |
Standard home loan | Finance purchase of existing home (including new builds) |
Deposit required | |
Construction loan | At least 5% (but ideally 20%) |
Standard home loan | At least 5% (but ideally 20%) |
Finance provided | |
Construction loan | Gradually as payments are required at various stages by the builder |
Standard home loan | All loan funds are released at once |
Interest | |
Construction loan | Charged on amounts drawn down only |
Standard home loan | Charged on the full loan amount from the start |
Repayments | |
Construction loan | Usually interest-only during construction |
Standard home loan | Usually principal and interest, but some loans offer an interest-only option for a set period |
| Construction loan | Standard home loan | |
|---|---|---|
Purpose | Finance the construction of a new home or major renovation | Finance purchase of existing home (including new builds) |
Deposit required | At least 5% (but ideally 20%) | At least 5% (but ideally 20%) |
Finance provided | Gradually as payments are required at various stages by the builder | All loan funds are released at once |
Interest | Charged on amounts drawn down only | Charged on the full loan amount from the start |
Repayments | Usually interest-only during construction | Usually principal and interest, but some loans offer an interest-only option for a set period |
Why go interest-only on a construction loan?
Mansour Soltani, Money's Home Loans Expert
“While you’re doing the construction, most lenders will allow you to pay interest-only on your loan for 12, 18 or 24 months. The reason a lot of borrowers want to do that is for cash flow. While you're building you're generally renting, which is a big added expense and lower repayments can be a big help.”
Mansour Soltani, Money's Home Loans Expert
Construction home loan progress payments (how the loan funds are released)
1
Foundations
This is when your foundation slab is measured and poured, with some of the plumbing being installed. (Approx 15-20% of total loan). This may also include your initial deposit to the builder which is generally 5% of your building contract price, according to Mansour.
2
Frame
This is the state where the exterior frame is built, including roofing, windows, walls and trusses. (Approx 20% of total loan).
3
Lock up
Construction of internal walls, doors, and insulation of the home. This includes everything required to ‘lock up’ your property and make it weathertight. (Approx 20% of total loan).
4
Fit-out
The finer details of the home are added such as shelving, kitchen & bathroom cabinetry, tiles and internal cladding. (Approx 30% of total loan).
5
Completion
The final touches that complete the home. This may include installation of retaining walls or fences as well as cleaning of the site. (Approx 10% of total loan).
Here’s a tip: With the exception of the final payment upon completion, your lender won't always inspect the property at each stage. Instead, it will be your responsibility to check the work has been finished, and to then forward the builder’s invoice to the lender for payment.
Who controls construction payments: Builder vs bank
Mansour Soltani, Money's Home Loans Expert
"When you're negotiating with your builder, they will outline how much they want to be paid at each stage. But it's actually the bank that will dictate how the builder gets paid. As a client, it’s best to have that conversation upfront with your builder to set the expectation that at the end of the day, how and when the payments are made will be up to the bank and not you."
Mansour Soltani, Money's Home Loans Expert
How to apply for a construction home loan
To apply for a construction loan, you’ll need to give the lender all the usual documentation required when taking out a standard home loan, including:
- Proof of ID (e.g. driver’s licence, passport)
- Proof of income (e.g. payslips for PAYG employees, BAS statements for businesses)
- 3-6 months of bank statements showing your living expenses & proof of savings
- Proof of your other debts (e.g. credit cards, personal loans)
Other documents you’ll need for a construction loan application
A contract of sale for the land you’re building on
You’ll need to show a signed contract of sale for the land you plan to build on or some other proof of ownership (e.g. a property title with your name on it) before a lender can approve you for a building loan.
A fixed-price building contract
While some builders are reluctant to offer fixed-price building contracts (due to quickly-rising costs), it’s usually a requirement of the lender that the contract is based on a fixed price.
This will generally need to include:
- An outline of each construction stage
- A progress payment schedule
- A construction timeline
- Total costs for the project
The lender may also ask for a copy of the builder’s licence.
Council approved building plans & permits
Your builder or architect will also provide this and will include all details of your home including layout, size, specifications, materials used and more. You can also search for extracts of building approval records for your property on your local council’s website.
Proof of insurance
The lender will want proof that the property and project are adequately insured throughout. This generally includes:
- Builder’s all risk insurance: Also known as home builder's insurance, it covers risk to the building during construction.
- Domestic/home warranty insurance: You’ll need this if you’re using a registered builder. It covers risks like non-completion due to the builder's death, insolvency, or disappearance, as well as structural defects from builder negligence.
- Public liability insurance: Covers damage to property or injury to people relating to the construction.
The lender will conduct an ‘as if complete’ valuation
Before your construction loan is formally approved your lender will arrange for a valuation of the home’s value as if it was completed. To do this, the valuer will need both the building contract and the building plans.
The estimate of the valuation on completion will be based on recent sale prices of other comparable homes in the area. This is done to ensure you’re not overspending on your build, and that your home will be worth more than the loan amount when completed (i.e. avoiding negative equity).
The average build time for detached houses in Australia increased from 10.3 months to 11.7 months in 2022/23, according to Master Builders Australia. Keep your potential build time in mind when applying for your construction loan.
What is an owner-builder construction loan?
If you plan to build your home yourself, you'll need an owner builder construction loan. This is different to a construction loan, which requires a contract with a qualified builder.
Owner-builder construction loans are available from only a few lenders, and getting approved for this type of loan can be difficult due to the perceived risks associated with owner-builder projects (e.g. cost overruns). If you’re a licensed builder you may be able to secure a loan for up to 80% of the build’s cost — if you’re not, you may only be able to borrow 50-70%.
Because lenders are so strict with these types of loans, before you apply you should make sure you have:
- A deposit of at least 20% if possible.
- A good credit score and minimal debt
- A detailed plan for construction including cost estimates and quotes for tradesmen and materials
- Your name on the property title
- A permit to build on your property (depending on your state)
Since not all lenders offer these types of loans, it may be better to speak to a mortgage broker to help you find the right product.
Can I build or renovate without a construction loan?
You generally need a construction loan to build a new home or carry out major structural renovations to a home. Lenders are usually reluctant to provide finance for a major building project upfront through a standard home loan.
However, for non-structural work, a construction mortgage may not be necessary. Instead, if you have a high level of equity in your property, you may be able to refinance your home loan to borrow more (known as a top-up).
Our home loans expert, Mansour, offers the following example:
- “Let's think about a property owner with a home worth $1 million and $500,000 of equity. In other words, their home loan is $500,000."
- “And let’s say they want to do a couple of non-structural renos costing $200,000 in total. What they can do is talk to their bank or broker and say, ‘I want to release equity’."
- “If the bank approves it, it will increase their existing loan from $500,000 to $700,000, with a new separate loan account the borrower can withdraw from to pay for the renovations as they need it."
- “Now instead of the 50% equity they started with, it's back at 30%.”
What about home renovation loans?
Another option for smaller renovations is a home renovation loan. These are different to construction loans and are essentially personal loans that can be used to pay for non-structural renovations.
Home renovation loans are generally easier and faster to apply for, with shorter repayment terms (1-5 years typically). However, personal loan interest rates tend to be higher than what’s available with a construction loan.
