Construction loans vs home loans: Free up cashflow with a construction loan for your new home build
Planning your new home? When it comes to financing, you might assume a traditional home loan is the way to go. But did you know a construction loan could free up cash exactly when you need it most during your build?
A construction loan gives you access to funding in stages as the build progresses, offering the ultimate flexibility. And if you're building a new home to live in or are starting a knockdown rebuild project, a construction loan is structured in a way that can assist you to manage cashflow when you need it most.
What is a construction loan?
A construction loan, also known as a building loan, provides progress payments in stages throughout the new home building process. With a construction loan, you pay only for each stage of the build, freeing up cash flow compared to a standard home loan, where you start paying interest on the full amount right away.
Construction loans can only be used for certain types of projects including building a new home, knockdown rebuild of an existing property and in some cases major renovations. Many lenders offer construction home loans so this type of loan may be worth considering instead of a standard home loan. If you're unsure, talk to your mortgage broker.
How do construction loans work?
To qualify for a construction loan, you’ll need a fixed-price building contract with a licensed builder. Your lender requires a breakdown of costs for each stage of construction to understand the scope of the project and how the loan amount aligns with the expected value of your home which they will find in the building contract.
Once loans are approved, prior to funding the construction stages, council approved building plans will also be required.
Once the home loan is approved, the lender can fund the land purchase and can even release payments to the builder for building deposits in some cases. Soon after your construction commences and is funded in five to six stages by the lender, in line with the construction process and costs.
Repayments on the construction loan are almost always interest only. This means you’re not actually paying the loan down but gives you the advantage of lower repayments during the construction period.
As each stage is complete, your builder will invoice the bank who will, in turn, pay your invoice. The loan increases in accordance with the invoice amount from the builder. Your lender may also conduct inspections at each stage to ensure loan funds are being used as agreed.
Construction home loan progress payment schedule
The stages or milestones of construction can vary from builder to builder and the lender funds accordingly. It’s important to remember, each build has a unique funding schedule customised to your needs and building requirements. Here's what you can expect.
- Deposit: Approximately 5%
- Slab: The land is prepared and the foundations laid. Progress payment: approximately 10-15% depending on whether the deposit has been paid (sometimes the slab and deposit payments are combined).
- Frame: Exterior frame, support structures and/or walls are installed. This stage may also include conduits for electrical and plumbing. Progress payment: approximately 20%.
- Lock-up stage: Remaining windows, doors, external walls are finished so the property is lockable. Progress payment: approximately 30%.
- Fit-out stage: Includes internal fittings and fixtures, plumbing and electrical, lights etc. Progress payment: approximately 20%.
- Construction complete: The last contracted stage including any final painting, fencing, site clean-up and you're ready to get your keys. This is when the final progress payment is made: approximately 10%.
Construction on your new home will need to start in the timeframe agreed on the contract, such as within six months. Depending on the loan terms, you'll likely have one to two years before construction needs to be completed.
Once the property is complete, the loan will revert to principal and interest repayments more like a typical mortgage.
The benefits of construction home loans
Interest only payments during construction
One of the biggest advantages of construction home loans is most lenders require interest only repayments while your new home is being built. This means you have extra cash flow to cover rent and other expenses while making initial mortgage payments. It also buys you some time to save for other costs such as landscaping, fencing, moving costs or furniture for your new home.
Flexible payment structure
Construction loans usually offer a progressive drawdown payment structure so you only have to pay interest on the portion of the loan that has been paid to date. This only applies if you haven't chosen an interest only period.
Use equity in your existing property
If you already own a home or have an existing mortgage, you may be able to use the equity in your current home as security for your construction loan. If you're knocking down and rebuilding, you may be able to draw on the equity from your land.
Construction loan vs regular home loan: key differences
Drawdown versus lump sum payments
Construction loan: Funds are released in stages and you only pay interest on the amount drawn down at each stage.
Standard home loan: The full loan is provided at the start and you begin paying interest on the total amount from that date.
Repayment structure
Construction loan: Repayments are likely to be interest-only while your home is being built. When the home is complete, the loan changes to principal and interest repayments.
Standard home loan: You pay principal and interest from the beginning which means you start paying down both immediately.
Valuation and approval
Construction loan: The approval process is more detailed with lenders likely to review the building plans and request a detailed cost breakdown. There are also staged valuations while your new home is being built.
Standard home loan: Loan approval is usually based on estimated market value of the completed home.
What you need to know about construction loans
- Home construction loans usually have interest only variable interest rates which means initial repayments can be unpredictable. It can also be difficult to predict interest rates when construction is complete and you're ready to move to a traditional principal and interest loan.
- To request progress payments as agreed in your loan contract, you'll need to confirm the work has been completed and supply a signed drawdown request form along with your builder's invoice to your construction loan provider.
- Before final payment can be made, your lender may require a copy of your Building Insurance Policy or Certificate of Currency as well as a Certificate of Occupancy if required by your state or territory.
Insider knowledge from a loan specialist
If you're considering a construction loan, finance specialist Ansh Sethi from Loan Studio, recommends talking to a broker early on.
"Starting from the beginning with a good broker is the easiest way of planning the entire process,” Ansh explains. “A broker can assist you in securing land and securing building site starts that are suitable for your timeline. We can assist with planning deposits, savings targets, equity releases and more.”
In addition, Ansh says with the complexity of a construction loan, it's essential to have someone knowledgeable on hand to ensure you're getting the right loan for your needs and provide guidance along the way.
"It's important to have a broker to help you understand cashflow through construction,” Ansh says. “You may be paying off another home or even paying rent while mortgage payments are increasing. So, plan for these increases and leave some savings to cover cashflow shortfalls."
Ultimately, the right home loan for your project will be dependent on a number of factors including the type of home you want to buy, available equity and cash flow. If you're considering a construction loan, keep in mind that lenders offer construction loans with a variety of different structures and obligations. Like with any large loan amount, it's essential to seek independent advice before signing.
