A simple overview of construction loans
A construction loan, also known as a ‘building loan’, is designed for borrowers constructing a new home or investment property. It can also be used for a house and land package, as well as major renovations or structural improvements to an existing property.
Construction loan interest rates typically start at around 6% p.a., though the exact rate will vary based on several factors, including the lender, the purpose of the loan and your financial situation.
How does a construction loan work?
A construction loan works similarly to a standard home loan, but with some key differences.
- Unlike a traditional mortgage, 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 may be able to 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 loan 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 as little as a 5% deposit of the build’s value may be possible but may mean there are extra costs, like lender’s mortgage insurance (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.
Who controls construction payments: The builder or bank?
Mansour Soltani, Money.com.au'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.com.au's Home Loans Expert
When might you need a construction loan?
You may need a construction loan when you plan to:
- Build on land you’ve purchased: If you’ve already bought land with the intention of building a home or investment property, a construction loan will cover the building costs as the project progresses.
- Buy a house and land package: This involves purchasing both a block of land and a home to be built on it. You would need a land loan to cover the cost of the land, while a construction loan would finance the building costs of the home.
- Demolish a property or undertake major renovations: If you're purchasing a property with plans to demolish it and build something new, or undertake significant renovations, a construction loan can cover these costs.
How construction loans are disbursed
Construction loans are typically paid out in stages as the building progresses. Instead of receiving the full loan amount upfront, funds are released based on completed milestones, ensuring that payments align with the construction process. A typical property development has five main construction stages:
1
Foundations
This is when your foundation slab is measured and poured, with some of the plumbing being installed. It usually accounts for 15-20% of the total loan and may also include your initial deposit to the builder, which is generally 5% of your building contract price.
2
Frame
This stage involves constructing the exterior frame, including the roofing, windows, walls, and trusses. It typically accounts for about 20% of the 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. This phase generally represents around 20% of the total loan.
4
Fit-out
At this point, the finer details of the home are added, including shelving, kitchen and bathroom cabinetry, tiles and internal cladding. This usually represents about 30% of the 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. It generally accounts for roughly 10% of the total loan.
Here's a tip...
Mansour Soltani, Money.com.au's Home Loans Expert
“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."
Mansour Soltani, Money.com.au's Home Loans Expert
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.com.au'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.com.au's Home Loans Expert
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. But that’s not always the case. Current interest rates for building loans on our database start from around 6% p.a., which is similar to what’s on offer with regular home loans.
Additionally, some lenders offer lower interest rates on eco-friendly construction loans for borrowers building or renovating homes with sustainable features. For instance, lenders like Bank Australia and Reduce Home Loans provide reduced interest rates and waive certain fees for eligible owner-occupiers and investors.
When comparing home loans, you may find that construction loans come with extra fees or stricter lending criteria, such as the need for detailed building plans. 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 $616,316 in Australia, while the average new loan for an existing property is $656,521, according to the ABS. Construction loans make up 10% of all residential loans, mortgages for existing properties make up 83%, and the rest are for newly-built properties or loans for major renovations.
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)
- 3-6 months of bank statements showing your living expenses & proof of savings
- Proof of income (e.g. payslips for PAYG employees, BAS statements for businesses)
- 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 and 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 property as if it was completed. To do this, the valuer will need both the building contract and the building plans.
The estimate of the value 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).
According to Master Builders Australia, the average build time for detached houses was 12.7 months in 2023-24, a 40% increase from the average of nine months in 2010-11. Keep your potential build time in mind when applying for your construction loan.
Can you 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 Soltani, 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.
