Compare construction loan rates in Australia from 6.14%

In this page:

• What is a construction loan?
• How do construction loans work?
• How do lenders charge interest on construction loans?
• Why are interest rates higher on construction loans?
• Pros and cons of construction loans
• What happens once construction is completed?

What is a construction loan?

As the name implies, a construction loan is designed for borrowers building a home or undergoing significant renovations, rather than buying an existing property.

Unlike a regular home loan, a construction or building loan covers expenses incurred as the building process takes shape.

Those taking out construction loans typically incur interest only repayments during the construction period. This means repayments stay relatively low while the home is being built.

How do construction loans work?

Construction loans operate through a process known as 'progressive drawdown.' The loan amount is progressively disbursed as different stages of the building or renovation works are completed.

When building or renovating a home using a construction mortgage, you'll only pay interest on the funds used until the building process is completed.

Your builder will outline the total funds needed to construct your home, dividing expected costs into several segments.

Your lender will make payments to your builder at every stage of construction. As each phase is completed, your lender will require you to present an invoice from your builder to issue payment.

Your lender will likely be very involved in the process. Typically, they will send someone to inspect the progress of construction before releasing the next payment to your builder.

What are the six stages of a home build?

Construction of a house is typically divided into six stages:

1. Contract & deposit
   The homeowner will sign the paperwork and pay the builder the deposit needed in order to begin construction.
2. Slab down
   The foundation of the property is created, including ground leveling, the concrete slab, plumbing, and waterproofing of the foundations.
3. Frame
   This stage includes the construction of the home’s frame, which may involve brickwork, roofing, and trusses.
4. Lockup
   External walls are completed, and windows and doors are installed to secure the building.
5. Fitout
   This stage covers internal items such as fittings and fixtures, plasterboard, partial installation of cupboards and benches, further plumbing, electrical work, and the likes.
6. Completion
   Towards the end of construction, final payments are made for builders, equipment, and other contracted services. This stage also covers finishing touches such as cleaning, painting, and other details.

How do lenders charge interest on construction loans?

If you have a construction loan, your lender will only charge interest on the amount of credit drawn down at any particular stage of construction.

For example, if you're approved for a $300,000 construction loan and you've spent $100,000 on the building process so far, you'll only pay interest on the $100,000 that's been drawn down.

Throughout construction, your repayments will be interest only. At the end of the build process, you may ask your lender if you can continue making interest only repayments, or you could change your loan to principal and interest and begin repaying your outstanding balance.

Some homeowners choose to refinance their construction loan after the build process is finished. Some construction loans, meanwhile, automatically convert to a standard mortgage when the house is fully constructed.

Why are interest rates higher on construction loans?

Construction loans tend to have higher interest rates than traditional principal & interest (P&I) home loans. This is largely due to three factors:

1. Home loans with interest only repayments are typically a higher risk for a lender. A person making interest only repayments isn't paying off their debt, after all.
   
   
2. Homes under construction also present more risk to a lender. Much of the asset used as security on the loan (the property) doesn’t exist yet, and complications could arise as it's built.
   
   
3. It’s tough for a lender to determine your final loan-to-value ratio (LVR) as the home is being built and money dished out as needed. Complications or cost blowouts could reduce the equilibrium between your deposit and the value of the home.

Various fees associated with construction loans may also be higher than those of traditional mortgages. The valuation fee, for example, might be higher as the valuer must assess the home’s worth at each stage of construction.

Pros and cons of construction loans

There are a few factors to weigh up when considering building a home versus buying an existing one, not least of which involve taking out a construction loan.

Pros

1. Smaller repayments
   Lenders dish out money for each step of construction, meaning you only pay interest on the amount used at a given point in time. Additionally, construction home loan repayments are generally interest only during the construction process, making them more manageable in that time.
2. Protection at each stage
   Construction loans are usually dished out in stages, with the lender and valuer assessing work at each stage. This provides some protection from dodgy tradies if, say, the slab is poured poorly, as there are more eyes watching the work.
3. Less stamp duty and potential grants
   How much stamp duty a homebuyer must pay depends on how much they spend on a property, and since buying vacant land is typically cheaper than buying an existing house, a person building a home will likely pay less stamp duty. On top of that, many state governments offer stamp duty concessions and monetary grants to those building new dwellings.

Cons

1. Challenges of building
   There're lots of unknowns associated with building a home, as you'll know if you've ever watched an episode of Grand Designs. Poor weather, dodgy tradies, and material shortages can draw out the process and add to the cost of construction. Budgets can easily be blown out, and the final product might not be what you had in mind when you started.
2. Higher rates
   Interest rates are typically higher on construction loans. If costs blow out, that can also result in a higher LVR than expected.
3. More overall interest paid 
   If you make interest only repayments during the construction phase and your home loan repayments later roll into principal and interest, you will ultimately pay more interest than if you made principal and interest repayments from the get-go. You could also face higher repayments, as the timeline in which you're expected to repay the principal balance could be condensed into say, 28 years, rather than 30 years.

What happens once construction is completed?

Construction loans usually only demand interest only repayments while the build process is underway, meaning repayments are lower during this phase.

Once construction ends, the home loan might be transformed into a regular mortgage with principal and interest payments. This means you will start to pay down the principal of the loan, which could see your regular repayments jump significantly. 

If the total life of the home loan, including the construction phase, is 30 years, the time in which you're paying off your principal balance could be condensed into 28 years. This can make your ongoing repayments larger than they might have been had you bought an established property.

However, building your own abode might work out to be more cost-effective overall than buying an established house, and you'll get to craft it just the way you like it.