Understanding progress payments, construction loan repayments and what lenders look for when financing a new home.
Building a new home is an exciting prospect, whether you're purchasing vacant land, undertaking a knockdown rebuild or creating a custom-designed home.
However, financing a construction project works differently from arranging a traditional home loan.
Unlike a standard home loan, where funds are generally advanced at settlement, a construction loan allows funds to be released progressively as building work is completed.
Understanding how this process works, what lenders require and how repayments are structured can help you avoid unnecessary delays and unexpected financial pressure.
At Balcombe Financial, we assist clients with residential construction finance, helping them navigate lender requirements and structure funding around their building projects.
How Does a Construction Loan Work?
A construction loan is designed to finance the building of a new home, with funds generally released in stages rather than as one lump sum.
These payments are known as progressive drawdowns.
Rather than providing the builder with the entire construction amount upfront, the lender releases funds as agreed stages of the building contract are completed.
Most residential construction contracts follow five main stages:
- Base stage: Site preparation, foundations and concrete slab.
- Frame stage: Construction of the home's structural framework.
- Lock-up stage: Installation of the roof, external walls, windows and external doors.
- Fixing stage: Internal fittings and finishes, including plastering, cabinetry and other contracted work.
- Completion stage: Final works and inspections before the property is ready for handover.
The lender assesses each progress payment request against the agreed construction contract and may require an inspection or other supporting evidence before releasing funds.
This structure helps ensure that the amount advanced reflects the progress of the building project.
How Are Construction Loan Repayments Calculated?
One of the main benefits of a construction loan is that borrowers will generally pay interest only on the funds that have been drawn down.
For example, consider a borrower with an approved $600,000 construction facility.
If the builder completes the first stage and $100,000 is drawn down, interest is initially calculated on that $100,000 rather than the full $600,000.
As additional construction stages are completed and further funds are released, the amount on which interest is charged increases.
Importantly, if you also have an existing loan secured against the land, interest will continue to apply to that outstanding balance.
Most lenders offer interest-only repayments during construction, with the loan generally transitioning to principal and interest repayments once the building is completed, subject to the loan arrangements.
This can be particularly beneficial for borrowers who are continuing to pay rent or manage other housing expenses while their new home is being built.
What Do Lenders Look for When Assessing a Construction Loan?
Construction lending involves more than simply assessing your income and borrowing capacity.
Lenders also need to understand the building project itself and whether the proposed construction can be completed within the available funding.
Typical requirements include:
- Evidence of income, savings, existing liabilities and borrowing capacity.
- A suitable deposit or sufficient equity in an existing property.
- A signed building contract, generally on a fixed-price basis.
- Building plans and relevant council or building approvals.
- Details of the registered builder, including required insurance.
- A progress payment schedule outlining the payments due at each construction stage.
- A satisfactory property valuation, including the proposed completed value.
The lender will also consider the overall cost of the project and whether sufficient funds are available to complete construction.
This is particularly important because the lender's valuation of the completed property may differ from the total amount you intend to spend.
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How Much Deposit Do You Need for a Construction Loan?
The deposit or equity required depends on the lender, the type of construction and your financial circumstances.
As a general guide, borrowing up to 80% of the lender's assessed property value may allow you to avoid Lenders Mortgage Insurance (LMI).
Some lenders may consider higher loan-to-value ratios, although this can involve additional requirements and LMI costs.
If you already own the land, the equity you hold in that property may contribute towards the overall funding structure.
For borrowers undertaking a knockdown rebuild, the existing property's value and any outstanding mortgage will also form part of the assessment.
The important consideration is not simply how much deposit you have saved, but whether your total available funds and approved lending are sufficient to complete the project.
Why Is a Fixed-Price Building Contract Important?
Most mainstream lenders prefer a fixed-price building contract with a suitably registered builder.
A fixed-price contract establishes the agreed cost of construction and provides a defined payment schedule.
This gives both the borrower and lender greater certainty about the project's funding requirements.
However, a fixed-price contract does not necessarily protect against every additional expense.
Changes to building specifications, variations requested during construction, unforeseen site conditions and items excluded from the contract can all increase the final cost.
For this reason, it is important to understand exactly what is included in the contract and maintain an appropriate financial buffer.
Cost-plus contracts and owner-builder arrangements may also be considered by some specialist lenders, although lending options are generally more limited.
Buying Land First or Arranging a House and Land Package
There are several ways to structure finance when building a new home.
House and land packages
These arrangements typically involve purchasing land and entering into a separate building contract, although the transactions may be marketed together as a package.
Depending on the lender and timing, the land purchase and construction funding may be assessed together.
Purchasing land before building
Some borrowers prefer to purchase a block of land first and arrange construction at a later date.
This provides greater flexibility when selecting a builder and finalising the design.
However, borrowers need to consider the cost of holding the land, construction commencement requirements and whether their financial position may change before building begins.
If the land is already financed, it may be possible to refinance the existing loan as part of the construction funding arrangements.
The most suitable structure will depend on your circumstances, the timing of the project and the lender's requirements.
What Happens if Construction Is Delayed or Costs Increase?
Building projects do not always proceed exactly as planned.
Weather conditions, labour availability, material delays, contract variations and approval requirements can all affect construction timeframes.
If the project takes longer than expected, borrowers may incur additional interest and holding costs.
Where construction costs increase, additional funds may need to be contributed by the borrower.
While it may be possible to request additional lending, approval is not guaranteed and will depend on the lender's assessment of your financial position, the property valuation and the revised project costs.
Lenders also have construction completion requirements, and extensions may be necessary if the building period exceeds the agreed timeframe.
Having sufficient funds available for contingencies is therefore an important part of planning a construction project.
Can You Finance a Major Renovation or Extension?
Construction finance is not limited to building an entirely new home.
Depending on the scope of work, a construction loan may also be appropriate for substantial renovations, extensions or structural alterations.
For example, adding a second storey or undertaking a major structural renovation may require staged funding similar to a new build.
Smaller renovations, particularly where the work does not involve significant structural changes, may be funded through an existing home loan, a loan increase or an equity release.
The appropriate financing arrangement will depend on the value of the property, the extent of the proposed work and the lender's policies.
Owner-builder projects generally require more specialised consideration, as many mainstream lenders restrict this type of lending.
How Long Does Construction Loan Approval Take?
Construction loan approval timeframes vary depending on the lender and the complexity of the project.
In addition to the usual financial assessment, lenders may need to review building contracts, obtain valuations and confirm that the proposed construction meets their lending requirements.
Once formal approval is issued and the necessary loan documentation and construction conditions have been satisfied, progress payments can begin in accordance with the lender's process.
Providing complete documentation early can help reduce unnecessary delays.
This is one reason why speaking with a finance broker before signing a building contract can be valuable.
Why Speak With Balcombe Financial Before You Build?
Construction lending can be more complex than a standard residential home loan.
Different lenders have different requirements relating to building contracts, deposits, valuations, construction timeframes and progress payments.
At Balcombe Financial, we work with a panel of more than 40 lenders and help clients understand their available options before committing to a building project.
Whether you're purchasing land, undertaking a knockdown rebuild in Bentleigh or planning a new home elsewhere in Melbourne, we can assist with assessing borrowing capacity, comparing lenders and structuring the finance to suit your circumstances.
Planning to build or renovate?
Speak directly with Michael Flinos at Balcombe Financial to discuss your construction finance options.
Call Michael on 0429 179 060 or book a consultation through our website.
General information only. Lending criteria, fees and loan features vary between lenders. All finance is subject to lender assessment and approval.
