What is a Construction Loan?
26 June 2014
Attempting the construction or major renovation of your own home comes with a whole host of stresses. Do your trust your builder? Do you trust yourself to build what you want? Have you planned properly? What kind of budget is a feasible one?
These are just some of the questions you need to ask yourself because as Scott Cam, or even the former police twins from The Block will tell you, the foundations of your construction don’t necessarily begin with the physical framework. The twins also found out that if you intend to flip the property once the construction is complete, you shouldn’t sell your property to an inside trader. But that is a story for another time.
The first thing to do is lay out the plans for your new home, draw them out and fully cost them: how do you want it to flow, how will it be built, is it double storey, single storey does it comply with council regulations? Once you know what you want, unless you plan to act as the owner-builder, you’ll need to acquire the services of a licenced builder. Find someone you trust, whose work you have seen and liked and who has outstanding references, and then go to the bank for what is called a ‘construction loan’. Having a builder on board is crucial to your funding as the loan necessitates a signed building contract with a licenced builder. Bottom line: no builder, no loan.
The Construction Loan
A construction loan is a mortgage agreement designed specifically for those who are building a new home. This is how it works:
You buy the vacant land first and then arrange to build on this land in an agreed timeframe (or you can make a deposit to the lender – usually 20% of the total cost although some will lend up to 95%). This provides the lender with security and a commitment from you.
The lender releases funds as progress is made. This is the more traditional method.
Point one speaks for itself, but let’s take a closer look at point two.
With a construction loan, the lender considers the total amount required to pay the builder to complete construction. This amount is then broken down into ‘progress draws’; separate payments that come out of your mortgage fund and are made at each phase of the building process to the builder. It is common that the lender will only require you to pay interest due on the amounts drawn. Let’s use this construction loan example to demonstrate.
If your loan is for $300,000 and your first invoice is for $55,000, the interest will be calculated on your account balance of $55,000 as well as fees. Full principal and interest payments begin once the house is built and you are in your home arguing over the curtains.
It is interesting to note that while the majority of construction loans are given to people building or renovating their own home, small scale developers can also get in on the action. The caveat here is that no more than four properties on a block of land may be built. Any more than this and the developer requires a solution in commercial finance.
One other point of note is the inclusion of a finance clause with your builder. By adding a finance clause you can protect yourself from potential disaster. The finance clause will:
- protect you against unsuitable finance;
- allow you to negate your contractual obligation if finance is not approved;
- removes land from the market while you wait for financial approval;
- gives you time to obtain finance
The Stages of Construction
When planning with your builder, the contract should include a clear outline of the stages of building and when these stages will be complete. There are usually five stages:
- Frame and Brickwork
- Lock Up
- Second Fix
At the Foundation stage, site cutting is done as well as initial plumbing. The next phase sees the frame go up as well brickwork, roofing and electrical fittings. In Lock u|Up stage, windows, doors, insulation etc. are fitted and the house is lockable. During the Second Fix stage, the gyprock is painted, the cupboards, benches and tiling are integrated, plumbing and electrical are completed and gutters and downpipes installed. You are then ready to put the final touches on the house at Completion stage.
These stages give you an idea of a payment schedule. A solid contract will list each of these stages with the percentage due to be paid to the builder. For instance perhaps each stage is worth 20% of the budget. Or perhaps the foundations cost more and therefore require 25% of the budget. This is something you need to work out with your builder. You also want a fixed price from your builder before you begin. Variations may occur, but a fixed price will lock in the majority of costs. Once you have this sorted, your lender will calculate the total amount due to the builder and divide the sum appropriately. Note: you generally have around two years to finish construction.
The lender will also value each stage at completion. As finance broker Martin Castilla told Smartline: “A benefit of a construction loan is that a valuer will inspect each stage of your construction on behalf of the lender before they approve each progressive payment. This means the lender is ‘double-checking’ the builder’s work and what they are invoicing for. It can provide some peace of mind for the new owner.”
Once the build is finished, it’s time to move in and start arguing about aesthetics. However, at least you can do this in the comfort of knowing that a well-paced construction with interest only payments and stage-by-stage funding made the build easier than it might have been.