How a construction loan works when building a new home
Starting your new home journey is an exciting milestone but there's a lot of information to get your head around. Understanding how the finances works is just as important as choosing your floorplan. If you're building, it's essential to learn about construction loans, how they work, and how they align with each stage of the building process.
Whether you're purchasing a house and land package or building on a block you own, you'll most likely need a type of home loan called a construction loan. These have a different structure and requirements to traditional home loans.
What is a construction loan?
A construction loan is a specialised type of bank loan designed for building a home. Unlike a home loan that’s paid out in a lump sum, a construction loan releases funds in stages known as drawdowns or progress payments, aligned with key milestones in the build process. You only pay interest on the amount the bank has drawn to date which helps to reduce and manage repayments during construction.
This staged approach helps cover the cost of construction as your home progresses. Once construction is complete and the loan is fully drawn, the loan transitions into a standard mortgage with principal and interest repayments.
Key differences between construction loans and traditional home loans
Construction loans are structured quite differently to traditional home loans. Knowing how they work can help avoid delays during your build according to Michael Edmondson, Henley’s New Home Loan Specialist.
Payment structure
“With a standard home loan, the bank or broker provides a lump sum once the contract is settled. With a construction loan, there are various stages, typically one for purchasing land and five for the build,” explains Michael. “Just remember, any contribution you are paying towards construction from your own funds will be required to be input prior to loan funds being utilised.”
Instead of receiving the full loan amount upfront, construction loans are paid out in instalments as each stage of construction is completed and approved. These instalments are called 'progressive drawdowns' or 'progress payments' and match the flow of construction costs through the project.
“After each stage is finished, your builder issues an invoice, which is then paid by the bank. You need to be comfortable with how the process flows, including the sequencing of approvals and payments because if one step is held up, it can delay the others,” says Michael.
Interest-only during construction
Most construction loans begin with an interest-only period, where you only pay interest on the funds that have been drawn down. As each progress payment is made, interest only is calculated on the amount released so far. This staged approach helps manage cash flow and reduce interest charges while your home is being built.
Staged valuations and approvals
Before each progress payment is released, the lender may require a site inspection or valuation to confirm the relevant stage such as the slab, external walls or roof has been completed.
More documentation
Construction loans typically require more paperwork upfront, including council-approved plans, a signed fixed-price contract with a licensed builder, insurance certificates and a detailed construction timeline. You’ll also need conditional approval from a lender with an Australian Credit Licence.
Flexible loan structure
These loans are designed to follow the construction timeline. While this flexibility is helpful, it also means you'll need to stay on top of schedules, approvals and loan repayments.
How a construction loan works
Whether you're building on land you already own or choosing a house and land package, the loan process is largely the same. Builders with access to titled blocks can sometimes streamline the process even further.
Michael explains that the process starts with understanding your borrowing power, so you have a clear idea of your budget before committing to a build.
There are typically five stages:
- Pre-approval and assessment: your lender assesses your finances and provides conditional approval.
- Land purchase and settlement: if you're buying land, this is the first payment stage.
- Contract signing and construction loan structuring: finalising the build contract and loan structure / formal approval.
- Construction begins: your builder starts work, and the loan is paid in progress payments at milestones like slab, frame, lock-up, fixing and completion.
- Loan conversion: after final progress payment is made, construction is complete, and the loan fully drawn, the loan rolls onto principal and interest repayments.
The importance of sequencing
One of the most important parts of the process is getting the sequence right. Each stage requires certain parts of the project to be completed before funds can be released for the next.
“The sequencing matters,” says Michael. “If something gets missed or delayed, every other stage can be pushed back. That’s why working with someone who understands the build process is so important.”
Poor sequencing can lead to unnecessary delays, additional costs and unwanted stress. For example, delays in finalising your loan can delay starting construction which in turn can delay progress payments and affect your builder’s timeline. Having a finance broker who understands construction loans can help ensure each step happens in the right order.
A typical progress payment schedule
The staged approach of a construction loan ensures that funds are only released once specific milestones are completed, keeping the build on track and aligned with lender requirements.
Here’s what a typical progress payment schedule might look like:
- 5% – Initial deposit
- 15% – Slab stage
- 15% – Frame stage
- 35% – Lock-up stage
- 25% – Fit-out stage
- 10% – Completion stage
“Our progress payment structure follows HIA guidelines, which align with most lenders' expectations,” says Michael. "As each stage is completed, your builder sends an invoice to the client for authorisation and forwarding to the bank, which when drawn increases the loan amount accordingly. Your lender may also conduct inspections at each stage to ensure loan funds are being used as agreed."
Applying for a construction home loan
The amount you can borrow is assessed just like it would be for a traditional home loan, based on your financial situation, income, credit history and expenses. Normal lending criteria apply to construction loans. Lenders also consider the total cost to build the home and the estimated property value upon completion.
Michael says that while most construction loans from major lenders offer competitive interest rates, some third-tier lenders may apply a slightly higher interest loan rate during the construction phase.
If you have an existing home loan, it can impact your ability to secure finance for a new build. Lenders will take your loan repayments on your existing property, debt levels and financial commitments into account. Be sure to get independent advice based on your personal circumstances.
The deposit
Your deposit amount is typically determined by the builder or developer, not the loan type. For most home buyers, this ranges between 5% and 20%, depending on your lender and situation. If you're wondering how much deposit you’ll need, your finance consultant can help you estimate this based on your overall financial position. Remember to budget for other expenses like government fees and lender-related costs.
After construction
Once construction is finished, final inspection is done and the final payment is made to the builder, your loan then changes to standard principal and interest repayments. This is when regular mortgage payments begin. Some construction loans may also offer features like an offset account, which can help reduce your loan balance and the amount of charged interest over the life of the loan (terms and conditions will apply).
Construction loans and licensed builders
Lenders who offer construction loans require your home to be built by a licensed builder. This ensures the construction meets building codes and reduces the risk for both you and the lender during the construction process.
You'll need a signed building contract, detailed plans and a breakdown of costs. “Most lenders won’t approve a construction loan unless a licensed builder is managing the build,” says Michael. “They need to know the work is being done properly, by someone with the right qualifications and relevant insurances.”
Builders like Henley are experienced with lender requirements and can provide the necessary documentation to keep things moving.
Benefits of working with an in-house finance expert
Building a new home involves more moving parts than buying an existing one. Working with a builder's in-house finance expert helps make the process easier and more efficient.
“A finance specialist working as part of your builder's team has direct access to the construction supervisor, estimators and draftees,” says Michael. “If an issue arises, they can pick up the phone and resolve it quickly, keeping everything moving.”
An in-house specialist can also help with the following:
- Connect you with mortgage brokers who can help you find the best home loan for your needs
- Guide you through key steps such as credit approval and liaising with your project planner to organise your fixed price building contract
- Help you understand your eligibility for lenders mortgage insurance (if applicable) and clarify deposit requirements
- Throughout the construction period, they can monitor progress to ensure nothing delays your progress payments
Unlike third-party brokers, in-house finance specialists understand construction timelines and can liaise directly with your builder, which reduces delays and miscommunication.
Ready to build a new home?
Getting your finance sorted early and working with the right builder can make the journey to build your own home a whole lot smoother.
If you're ready to take the next step, our in-house team is here to help guide you through every stage.
Talk to our finance specialists and get started today.
