Understanding how a construction loan works

What makes construction lending different?

The difference between a construction loan and a standard home loan is that instead of a lump sum payment at settlement, a construction loan is drawn down in stages. 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.

Finance approval

Before the lender can approve a construction loan, they will need the following documents:

• A copy of the Land Contract or Rates Notice if the land is already owned
• A copy of the Fixed Price Building Contract detailing the amount and timing of any progress payments
• A copy of the building specifications
• A copy of the Council Approved plans/drawings
• Contractors All Risk Insurance
• Evidence of any deposits paid on the land/or house
• FHOG application form (if applicable)
• Stamp Duty Rebate Form (if applicable)

The documents are then given to the Valuer (by the lender) so that they can prepare their Valuation Report for the chosen lender. The Valuer will supply BOTH a “land only” and “on completion” Valuation Report to the Lender.

The security value for construction loans is based on the value of the land, plus the construction cost, as if it’s completed (i.e. ‘on-completion’ valuation). The construction costs are specified in the builder’s fixed price tender.

The lender may require construction within a specific time frame and serviceability is assessed based on the client’s ability to service the land loan plus the construction costs.

The Construction Period

• The clients full deposit is required at land settlement
• The Lender then funds the balance of land settlement
• From date of settlement of the land, the Borrower will commence interest only payments monthly
• The Lender will then fund 100% of the Building Cost (as per agreed amounts)
• If there are other, additional inclusions to the Building Contract by way of Variations to the Contract, the client needs to ensure that they have sufficient cash to meet these costs at the end of the construction period e.g.  upgrading taps or installation of a pool
• At each construction milestone, as documented in the Building Contract, the Builder will issue a Progress Payment invoice to the client
• The client then signs to authorise payment and sends a copy to the Lender
• The Lender makes the progress payment directly to the Builder by drawing the funds from the Loan Account
• A Progress Valuation Inspection Report may be required by some lenders PRIOR to making the Payment to the Builder.

On Completion

• Certificate of Occupancy is issued
• The client will supply the Lender a copy of the Building Insurance Policy for the home
• A FINAL Progress Valuation Inspection Report will be required by most lenders PRIOR to making the FINAL Payment to the Builder​
• The Lender makes the FINAL progress payment to the Builder by drawing the funds from the Loan Account

Loan Repayments

• Constructions loans are usually written at variable interest rates given that they are advanced progressively over time.
• Until the loan is fully drawn and the house completed, (when the Certificate of Occupancy is issued), Interest only (IO) payments are made at the end of each month.
• When the loan is fully drawn and house construction completed, the loan then converts to principal & interest (P&I) payments over the balance term left to run, unless of course originally requested to remain at IO repayments.

The Construction Process 

There are 8 fundamental steps – may vary slightly depending on the scenario:

1. Client obtains funding Pre-Approval
2. Select the Builder and Design of Home
3. Tender Process (site costs)
4. Plans are drawn
   • Tender is signed
   • Deposit paid
   • Plans drawn
   • Plans submitted to council
   • Proof of Finance provided to the builder
5. Contracts are signed
6. Council approval
7. Construction Begins: A builder normally requires progress payments at the following stages as a guide:

• Slab poured
• Frame up
• Lock up (brick work laid, windows installed and roof complete)
• Fit out (internal walls up, tiling, and wet areas complete)
• Completion (painting finished, site cleaned ready for handover to client)

8. Construction Complete

• Unless arranged beforehand, the client can now go about having items such as landscaping, curtains, floor coverings, letterbox, fences, security doors etc. installed. Most builders will not allow other contractors on site until handover of the property.

Common issues

The most common problem a client faces is the cost of getting the home complete.  This is due to many factors including:

• Late changes to fixtures and fittings specifications
• Additional costs due to additional site requirements
• Forgetting to include all additional items such as fencing, driveway, and turf and landscaping that are generally not included in the builder’s specifications

Planning for any variances upfront, means clients have the flexibility in the future to cover these changes as required or as their requirements change.

What if construction costs increase?

Additional site costs are sometimes required, and this will increase the construction costs. This reinforces the need for borrowers to have some additional funds set aside for these types of unforeseen costs. The lender will always retain sufficient funds to complete the construction, commonly called “on a ‘cost to complete’ basis”.

For example;

If we assume the first progress payment request (as set out in the contract) was $30,000, however due to the need to undertake some additional site work for $2,000, the first progress payment has increased to $32,000. The lender would not draw the additional $2,000 from the loan and get it back from the client at a later stage, as this may result in the loan being fully drawn, with $2,000 worth of work still to be completed on the home – so the client would bear this cost.

 Example of a construction loan detailing the stages and how funds have been appropriated;

The below table indicates the loan balance at each stage – land price $250,000 and construction $350,000 and then the repayments (5% int rate used) that will be paid as each stage is appropriated.

Note some of the specific lender policies and criteria may vary – however this gives an overview of construction funding.

Anthony Landahl | Equilibria Finance

Note: This is for general information purposes only and does not constitute advice. With all of these options there are a number of considerations outside the scope of what is covered in this article. Please ensure your personal circumstances are taken into consideration.