Construction Loans Explained: How Building Finance Works

The short answer

A construction loan funds a build in stages, paying your builder as each stage is completed. You only pay interest on what’s been drawn so far.

Construction lending has more moving parts than a standard home loan, and fewer lenders offer it. Planning the finance properly before you sign a building contract makes the whole project smoother.

How construction loans work

Instead of paying the builder in one lump sum, the lender releases funds in stages as the build progresses. These are called progress payments, and typically follow stages like:

1. Deposit: paid to the builder when you sign the contract.
2. Base or slab: the foundations are laid.
3. Frame: the frame of the home goes up.
4. Lock-up: external walls, windows and doors are in.
5. Fixing: internal fittings, cabinetry and fixtures.
6. Practical completion: the home is finished and handed over.

At each stage, the builder sends an invoice, and the lender usually inspects or reviews the progress before releasing the payment.

Your contribution goes in first. Most often, you pay all of your own contribution towards the build before the lender pays anything, and the lender then funds the remainder. That means you need your full contribution ready upfront. It’s not something you can save towards during construction.

Interest during the build, and your cash flow

You only pay interest on the amount drawn so far, so repayments start small and grow as the build progresses. Most lenders set the loan to interest only during construction, then switch to principal and interest once it’s complete.

If you’re renting while you build, you may be paying rent and loan interest at the same time. Plan your cash flow for the full build, which can take a year or more.

What lenders need

• The land: owned already, or being bought as part of the loan.
• A fixed-price building contract: with a licensed builder.
• Council-approved plans and specifications
• Builder’s insurance: such as home warranty insurance.
• A valuation “as if complete”: the lender values the land plus the finished home.

Larger projects: builds over about $1 million usually require a quantity surveyor. They provide an independent cost report upfront and check each stage of work before the lender releases payments.

Not every lender does construction

Construction lending takes more work to manage, so not all lenders offer it. Those that do often:

• Lend a lower percentage: maximum LVRs are usually lower than for an established home.
• Offer less LMI availability: borrowing above 80% can be harder, or not possible at some lenders.

That makes it even more important to choose the right lender from the start.

Owner builders

If you’re managing the build yourself as an owner builder, expect more stringent requirements. Fewer lenders will consider it, they’ll usually lend a lower percentage, and they’ll want more evidence of your experience, costings and approvals.

Variations and contingency

Changes or extras outside your fixed-price contract, called variations, usually need to be paid from your own funds before the lender releases further payments, unless they were approved as part of the loan.

Keep a contingency buffer for variations and unexpected costs, and talk to us before agreeing to changes mid-build.

Planning a build?

With access to over 40 lenders, our team of lending specialists can find a lender that suits your project, whether it’s a standard build, a larger project or an owner-builder, before you sign your building contract.

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General information only. This article does not consider your objectives, financial situation or needs and is not credit, financial or tax advice. Lender requirements vary. Seek advice from a licensed credit adviser before acting. Insight Property Finance.