How does a construction loan work for a new home?

With so many types of loans available, it can be confusing to know which one best suits your client needs. Luckily construction loans exist, and they’re simple to decode—as the name suggests, they’re the loan to opt for when building a new home or embarking on significant structural changes on a pre-existing home.

Construction loans work differently to regular loans however, and they can be tougher to get. To apply for one, you’ll need to show the lender the council approved building plans and fixed price building contract. Generally you’ll also be asked to make a deposit of 20% of the total cost.

Enlisting the services of a licensed builder will increase the chances of getting the loan. Although you can apply for the loan as an owner builder, unless you have your own building license, it’s unlikely you’ll get the go ahead (and it’s a big job!).

If your client is successful in getting a construction loan, they will receive payments throughout the building process as opposed to a lump sum at the start. This gradual payment arrangement is referred to as a ‘drawdown’. There are generally around five stages in which the payments will be received: the slabs being poured, the frame going up, the brickwork being completed, the lock up and finally, practical completion.

A valuer may also visit during the process. They will have been sent by the lender to ensure that everything is running to plan. Based on the valuer’s report, the lender will either continue the payments or alert your client of a problem.

While this payment arrangement can seem cumbersome, it means that they’ll be paying their builder and other contractors only as they complete the work. This can be beneficial should any issues arise, such as the deadlines, scope of the work and cost changing along the way. It can also help people feel more secure and avoid potential conflict, as no one is handing out the full amount before the work has finished. Another benefit of the spaced-out payments is that interest will only be charged on the amount drawn down, not the total.

And while having the valuer assess the work can be an added stress, it also provides an additional set of eyes—they might have noticed a problem your client had been unaware of, and they’ll be glad that they brought it to their attention.

Once the construction process is complete, the loan may change back to having a principal and interest arrangement, or remain interest only (this depends on the lender). The interest rate, which would have been higher than that of a regular loan during the build, will then become that of a standard rate.