How to build the home of your dreams and save on home loan interest while you do it
If you are looking to build your new home rather than buy an existing property, you need a different type of home loan known as a construction loan. A construction loan can also suit you if you are making major renovations to your existing home or to a property you have bought but which needs a bit (or a lot) of work before you call it home.
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Construction home loans for January 2017
|Loan||Interest rate (p.a.)||Comparison rate (p.a.)||Max LVR|
|NAB Flexiplus Mortgage - Standard||5.84%||90%|
|NAB Tailored Home Loan - Owner Occupier (P&I)||5.25%||5.38%||95%|
|Westpac Rocket Repay Home Loan - Principal and Interest||5.29%||5.43%||95%|
A snapshot definition of a construction loan, according to the experts
- Stuart Tucker | Former Aussie General Manager Marketing & Product
- Carla Baldock | RAMS Head of Product
- Neil Manuel | eMoney General Manager
Click here for video transcript:
Stuart Tucker : With the amount of development that's going on around Australia, particularly in some markets like southeast Queensland, Canberra and Western Sydney, construction loans are an important option for some customers.
Carla Baldock: The construction line is a loan that provides progressive payments, which allows a borrower to pay a builder as and when the builder progresses throughout the construction period.
Neil Manuel : If the first stage is only a $15,000 or $30,000 draw down, then your only paying interest on a $30,000 loan. By the end of the draw down or by the end of the actual building, only at that point is the loan fully drawn down. So only at that point will you be paying interest on the whole home loan.
Carla Baldock : The downside of a construction loan is that lenders typically require you to build your property within 12 months.
Stuart Tucker : They can be tricky because the banks sometimes are nervous about the valuations on unbuilt homes. So it's worthwhile talking to a mortgage broker and getting some good advice because going with the right lender could make a big difference.
A construction loan is a specific type of mortgage designed for people wanting to build a new home. Depending on the way a construction loan is set up, you may be able to purchase your vacant block of land first and then arrange to build on the land within a specified timeframe.
Construction loans aren't set up in quite the same way as a regular mortgage in the beginning. Instead, the lender considers the total amount you need to borrow in order to pay your builder, and then breaks down the full amount into separate payments called progress draws. These are percentages of the total building contract amount paid out of your mortgage funds to the builder throughout the construction process.
While progress draws are being made, the majority of lenders will only expect you to pay the interest due on the amounts that have been drawn. Your full principal and interest payments won't begin until after the handover has taken place and you have received the keys to your new home, meaning you save on interest during the construction process.
You will need to have signed a Building Contract with a licensed builder to be approved for this type of loan.
Owner builder mortgages
An owner builder mortgage is designed for those people who wish to build their own home without the help of a licensed builder. As banks and lenders use the property as security for your mortgage, many of them consider owner builder mortgages to be high risk. For this reason, few banks and lenders will accept applications for these types of home loans.
Additionally, those lenders that do offer owner builder mortgages will usually limit the loan amount to 60% of the total land value and construction cost. The lender will take into account the value of the vacant land as part of the valuation total. However, you should note that the actual completed value of the home is rarely taken into account when factoring in the value of the security property with owner builders. Instead, the lender will look closely at the quotes provided to form the estimated cost of materials and labour required to complete the construction and use this as a 'to be erected', or TBE valuation amount instead.
As part of the application process, you may need to provide quotes to verify your costings for materials and labour for an owner builder mortgage, although some estimates may be accepted. You can also arrange to set up your own progress draw payment amounts so that portions of your total loan amount can be forwarded to you to pay for work already completed on the home during the construction period.
Refinancing a loan can be an expensive process so you don't want to choose a construction loan which is right for you during the building process, but which doesn't fit your needs properly once your home is finished. Instead look for features you want and need, such as free additional repayments so that during your interest-only repayments period for example you can deposit more into your loan to get ahead before you have even moved in.
A construction loan is set up differently to a regular mortgage to include progress payments in stages to your builder, so if you intend to build a new home you do need one.
It's important to do some homework to be sure you have the right construction loan to suit your needs. Some lenders will charge a slightly higher interest rate during the construction period, this is often referred to as interest rate loading, so be sure you understand how much you'll be paying. You may also want the ability to make extra payments on your mortgage during the construction stage, so check that you can do this.
Construction loans are suitable for any borrower intending to build a new home on a vacant block of land. This includes buying a house and land package from a licensed builder, or conducting major renovations to an existing home, such as adding new rooms.
Property developers for small scale developments may also use construction loans, but these might only be available if you're building under a certain number of properties. If you're building a larger amount of properties (usually over four) most lenders will consider this to be larger-scale development, which will require commercial finance instead.Back to top
Obtaining an appropriate construction home loan can be complicated, but it's worth the trouble once it all comes together, especially if you are your own main contractor and your home loan is unconventional. In order to help make the process a little more understandable, the following points outline what has to take place:
- The first step is to have your plans professionally drawn up and fully costed before placing them before your lender for home loan approval. The lender will then have an appraiser complete a preliminary assessment of the assumed value once the house is completed from the plans you have submitted. Construction home loans require management by a local financier until the home is completed, as such loans are not sold on the secondary mortgage market. After completion you can arrange to have the construction home loan converted to a regular home loan.
- Your next step is to either make a deposit to the lender or purchase the lot of land that the home is to be built on. This acts as sufficient security for the loan at this stage. The lender needs to see the level of your commitment to the project and your equity in the project right from the beginning, goes a long way in demonstrating this commitment. It will help if you own your building block outright.
- Before committing yourself to the first offer made it will pay you to look around to see what other lenders are offering so that you can make a proper comparison. Construction home loan interest rates vary much more than rates on regular home loans, and can sometimes be as much a three percentage points higher.
- You must take out a builders risk insurance policy to protect yourself and your lender against any storm or fire damage. This is important even if your have contracted the work out to a builder who has commercial liability insurance. You will need the extra cover to fully protect your own interests and that of your lender for total coverage.
- Some construction loans are designed to finance the building of your home only, while others are framed around that of a more traditional mortgage. While the basic elements of the loan are much like any other, you may find it necessary to have the loan changed to a more traditional home loan after the construction is completed in order to get the range of benefits that a more flexible mortgage offers.
The construction process
With most licensed builders, the contract should include a section outlining exactly what stages will be completed throughout the construction of your home. In most cases, there will be five stages:
- Foundations/footings: this stage also includes site cutting and preparation, as well as running initial plumbing into trenches before pouring the slab;
- Frame and brickwork: this stage includes the first fix framing of the house, plus brickwork and roofing, as well as first fix electrical fittings;
- Lock Up: this stage includes installing windows and doors, along with gyprock or wall linings and any insulation if it's required. The home is lockable at this point;
- Second Fix: the second fix stage sees the gyprock flushed ready for painting, kitchen benches and cupboards installed, tiling started to wet areas, second fix plumbing done, second fix electrical work done, architraves, skirtings and cornices fitted and guttering, downpipes and eaves completed;
- Practical completion: the final stage of construction usually includes painting the home inside and out and adding those finishing touches, such as installing shower screens and walk-in robes.
Inside your building contract, you should see an itemised listing for each stage noted above. Alongside each stage will be a percentage number. This indicates what percentage of the total building contract amount is due to be paid to the builder after completion of each stage.
- Foundations/slab = 25%
- First Fix = 20%
- Lock Up/Internal Linings = 15%
- Second Fix = 25%
- Practical Completion = 15%
Your bank will work out exactly how much your building contract comes to, minus any deposits you've already paid to the builder and then divide up your total home loan amount to pay to the builder accordingly after each stage is complete.
Because of the inherent risks involved for the lender, construction home loans are normally only offered to borrowers who have very good credit histories. The eligibility criteria is much more stringent for construction home loan applicants than it is for borrowers applying for a more traditional home loan. The initial down payment that is required is usually quite significant, especially if the building lot is not of great value without a building on it, most lenders will want at least 20 percent of the total cost put down as a deposit.
Considerable costs are involved in building your own home. Where you can purchase an existing home with a comparatively small amount of money needed for a deposit, this is not the case with a construction home loan, as many lenders require you to own your own building lot outright as well as a 20 percent down payment. This is a factor that prevents many from borrowing a construction home loan in order to build themselves but prefer to buy an existing property with a more traditional mortgage that is easier to obtain.
But it's not just the cost you need to consider before choosing to build. There are a number of other factors you should be aware of when choosing a construction home loan:
Do I need to buy a house and land package to get a construction loan?
You don't technically need to buy a house and land package from one builder or developer to get a construction loan. You may have already purchased a vacant block of land earlier using a regular home loan. It's only when you sign a building contract with your licensed builder that you'll need a construction loan. Keep in mind that you will end up with two separate mortgages this way.
Do I have to use a licensed builder to construct my home?
The vast majority of banks and lenders will prefer that you choose a licensed builder to construct your home before they extend a construction loan for you. However, there are some lenders that will allow you to build your own home as an owner builder. This is ideal if you're a qualified tradesperson or if you have a building license of your own, but an owner builder loan isn't suited to the faint of heart.
What clauses are involved with a construction loan?
In some states of Australia you are able to include a finance clause when you sign your contract for your vacant block of land. This type of clause is quite common when purchasing vacant land or even an established home via private treaty sale (not at auction), where you're able to insert a clause that says "Subject to Finance".
You may also be able to include specific dates and other information that is relevant to your clause. For example, you can add that your clause is subject to finance being approved with a specific lender for no more than a specific interest rate and that your finance approval needs to be received by a specific date. Remember, in this instance your finance approval is the full formal approval, or unconditional approval from your bank.
The primary reason for adding specific information like this is to protect you against having to accept finance that isn't right for you or your situation. So, if you've already received a pre-approval from your lender and you already know your interest rate, you can enter this information into your clause.
For example: This contract is subject to obtaining finance with Westpac at an interest rate no higher than 6.11% on or before 12th December.
If your finance clause is written this way, you have some backup in case your bank suddenly decides to decline your mortgage application at the last minute. After all, if you've simply written "Subject to Finance" and nothing else, you might suddenly find that the vendor can insist you accept any finance at ridiculous interest rates just to comply with the contract. Of course, this is very rare – but it's not unheard of.
The ability to include a finance clause like this gives you several benefits:
- It helps to protect you against being forced to take out finance that isn't suited to you;
- It allows you to get out of your contractual obligation if your finance application doesn't get approved for whatever reason;
- It removes your block of land from the market while the agent waits to hear about your finance approval;
- It gives you time to obtain your finance.
What if a building contract changes?
There are some cases where a lender will make a construction loan more expensive. This is due to how the contract price might go up after you get an amendment on your home prepared. This can especially be difficult because the builder will end up having to reassess the value of the loan from the top. However, you can do a few things in order to keep this from being a problem down the road.
- Get your building contract completed and finalised before sending it to your lender.
- Pay for any new changes to your construction with your own money. You could also ask your builder to reimburse you in the event that you got any discounts out of something.
- Consult your lender if the changes are massive. You might need to wait a month for the lender to review the loan again.
- Be sure to simplify your changes. This is so it will be easier for the bank to make changes and to keep from being delayed in the process.
Just like a regular home loan, the way you compare a construction loan will have an impact on the value you get out of it. Here's what you should compare:
- Interest rates. You'll only be paying interest during the construction period, meaning the interest rate you receive will have an important bearing on the size of your repayments. Keep in mind that the advertised rate doesn't take into account the fees you will pay for the loan, so be sure to also look at the comparison rate, as this will have an impact on this.
- Fees. Some construction loans will have extra fees which they'll charge to cover the costs of having a valuer check your property after each stage of the building is completed. Some home loans can also charge extra administration fees for construction loans, so you may need to factor this into the total cost of your home loan. These fees are in addition to regular upfront fees such as application costs, valuation fees and more.
- Features. During the construction phase most features of your home loan will be unavailable, such as redraw and the ability to make additional repayments (this of course will depend on the particular loan), but it still pays to know what features you'll be able to use once the construction phase ends. Find out what features you want out of your home loan and then ensure you search for these during your comparison.
- Construction terms. You'll want to confirm what construction terms your loan will offer, including how long you can build for using the loan and the process for drawing down and accessing funds.
Always approach your bank or mortgage broker about a pre-approval for your construction loan before you go out looking at display homes. This will let you know exactly how much you're able to spend on your land and your construction costs as a combined total. This is also a great way to ensure you don't go over budget.
Check your builder's licence
Always check that the builder you are considering has a valid building licence. Your state's building license office can help you with this. You should also check whether you can find any claims being made against that particular builder.
Get industry help when selecting a builder
If you're not sure which building company to trust, always check with the Master Builders Association and the Housing Building Association (or Housing Industry Association).
Check your builder's qualifications
Double check that the builder you choose has all the qualifications and insurance policies in place before construction commences. Your building contract should show you whether the builder has arranged for indemnity insurance, public liability insurance and various other insurance coverage.
See the previous homes they've built
Ask the building consultant if they can give you details and addresses of previous homes they've built. Looking at the builder's display home might look impressive, but you really want to see the quality of an actual completed home for a regular person just like you as well.
Get an accurate estimate of how long it'll take to build
Ask your builder how long the construction process will take. Remember, you're paying interest on the progress payments for your mortgage throughout this time, so you need to know how long it will take. Some builders are happy to guarantee a specified timeframe for the construction process. Others are a little more ambiguous about how long it will take to build your home. In some states, builders are required to complete construction within a six month time limit.
Find out what your bank expects when making drawdown payments
Check with your bank how they want you to approve your progress payments. Some banks will allow you to verify this over the phone. Other banks will expect you to sign progress payment forms that need to be faxed or emailed to the correct bank department before the payment can be made. Double check that you have the right contact details, otherwise your builder might not get paid on time, which could delay the construction process.
Compare and organise insurance
Before your bank finalises the last progress payment and gives approval for the builder to hand over the keys to your new home, they will want to see that you have arranged adequate insurance coverage. You will need to call your insurance company and insure the property for the full replacement value. You'll also need to tell them which bank your mortgage is held with, as this will appear on your insurance policy as well. When you've done all this, ask your insurance company to provide you with a Certificate of Currency. This will list all those details for you so you can hand it to your bank.
Construction loan frequently asked questions
How much time do I have to construct my home?
Most construction loans give you up to two years to finish the construction of a new home. If you’ve purchased your vacant block of land as part of your construction loan, the time frame commences after your land purchase has settled.
How does a construction loan work?
While your full mortgage amount might be approved to cover the cost of the construction, the progress payments are divided into usually five portions. These are broken down to be paid to the builder after the completion of various stages of the construction. The exact proportion of your contract amount to be paid with each progress payment will be detailed in your building contract.
During the construction process, you are only expected to pay the interest due on the amount of money that has been drawn from your loan. When the construction is complete, your construction loan will revert to a regular mortgage with full principal and interest repayments.
What is a progress draw payment, or draw down?
During the construction process, your bank will pay your builder for each individual stage of work completed after it’s been done. Each individual payment is known as a ‘draw down’, or a progress payment.
Can I add external quotes to my construction loan?
There are times when you may want to include quotes from external contractors who aren’t with your builder as part of your total mortgage. This might include quotes for air conditioning, floor coverings, driveways or pergolas to be added. Some banks will allow you to add individual quotes to your building pack or bank pack that your builder gave you, which lets you include those things in your mortgage amount. The progress draw payments remain the same to your builder, but the payment for those external quotes won’t happen until after the builder has been paid first and your house is at practical completion stage.
What happens if my building costs go up?
Most builders try to offer ‘Fixed Price’ contracts. While the cost of your new home construction won’t change after this has been fixed for you, always be very wary of ‘variations’ added to your final costs by the builder. These can include changes in the footings/foundation price after soil testing has been conducted.
If your contract includes a ‘TBA’ or ‘NC’ item listed anywhere, ask for verification about this. These are the builder’s way of saying that your house price might be fixed, but there might be things that can change in cost that they won’t guarantee.
Price increases can also include any upgrades you may have made during your colour selections process. This is when you arrive at various suppliers to choose your tiles, paint, bricks, roofing and other items that go into your house. Your building contract will include an allocation to cover these things, but if you spend more than you intended, your costs will go up.
Most banks are quite understanding about this and will expect that all those final variations have been received by the time your finance approval is underway. Any changes in pricing after this time may require you to alert the bank to account for the extra, or they’ll need to be paid by you.
What percentage of the building costs am I able to borrow?
Most banks and lenders will let you borrow up to 95% of the value of the land plus the construction costs. Note that this doesn’t say ‘95% of market value’, as it would if you were buying an established home. Instead, banks use a ‘To Be Erected’, or TBE valuation to determine what percentage of your costs you can borrow.
This means the bank will use the actual market value of your land, or the purchase price shown on the purchase contract, whichever is lower. Then they’ll add the exact cost of your construction to your land value to arrive at a TBE valuation amount.
This is not the same as the market value of your property once the construction has been completed. If you’re careful with your spending, it could be possible to pay less money constructing your home than it is actually worth in market value once it’s completed. If this is the case, it is very possible to have your newly built home re-valued three months after completion to maximise your equity. This is ideal if you intend to refinance after construction is finished to help pay for finishing touches to your home.
What if my builder goes broke?
All builders in Australia are required to have adequate insurance to cover against this happening. If your builder does happen to go broke before your construction is complete, another builder can be appointed to complete the home. The insurance company will pay for any difference in costs that may arise.
Can I get an interest-only construction loan?
Yes, of course. In fact, almost all construction loans are set to interest-only payments during the progress draws period. Only after the construction is complete and the final draw down payment has been made will your loan revert to a full Principal and Interest payment, unless you specifically request for it to stay on Interest-Only payments.
Can I pay extra payments during the progress draw period?
Most banks will allow you to make extra payments off your mortgage while your loan is still in the progress draws stage. Some banks will even let you link a 100% offset account to your mortgage account while it’s still being drawn down. This helps you get ahead on your mortgage while the balance is still low and reduces how much interest you’ll pay overall. Always check with your bank that they’ll allow this.
Building your own home can mean you get everything exactly the way you want it and with a construction loan you remain in control of the building process at every stage.