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Construction loans and how they work

July 28, 2014 By Erin Peak Leave a Comment

construction loans - just how do they work?

With residential property prices rising across our capital cities, it’s no surprise that we’re also seeing a rise in construction loans as savvy home owners and buyers look for a cheaper alternative to buying and moving.

With residential property prices continuing to rise, it’s no surprise that ABS figures show eighteen consecutive monthly increases in owner occupier construction commitments up to May 2014. May’s ABS figures also revealed the value of construction loans have lifted in the last two years by over 20% – an indication that home owners may be increasingly looking to upgrade their homes through renovation or knock-down and rebuild as a cheaper alternative to moving.

If you’re outgrowing your home or find it’s looking a little rough around the edges, there are alternatives to buying another home and specific finance options to help you create the home of your dreams.

What is a construction loan?

When doing a major renovation or building a new home your finance needs are different to buying an established property. A construction loan is a specialised lending option for builders or renovators to help them through the process. These can be construction loans or home loans that have a construction facility.

How construction loans work

Unlike regular home loans where you typically receive a lump sum of the loan amount at settlement, construction loans are paid out in periodic progress payments from the lender at different stages of construction.

As a guide, there are usually up to five progress payments at stages including slabs poured, frame up, brickwork complete, lock up and practical completion.

Some lenders will send a valuer to check the work has actually been completed, and to an acceptable standard, before releasing the next payment. This can be a handy double-check measure for you!

Each progress payment is called a draw down, and interest is only charged on the amount drawn down at the time interest in calculated. So, if you have approval for a $250,000 loan but have only drawn down $80,000 – you’ll only be charged interest on that $80,000 until you make further draw downs.

Loan repayments are also interest only during the construction period, providing comfort and security to renovators and home builders by minimising their repayments during an expensive, and probably stressful, time.

Depending on the loan and lender, at the end of the construction process your loan can either revert to principal and interest or you may be able to keep it as interest only.

Advantages of construction loans

  • Protection. By making progress payments instead of giving the builder a lump sum up front, borrowers and their lenders can make sure that builders or contractors aren’t being paid for work that hasn’t been done, or done properly.

  • Less interest. You’re only charged interest on the amount drawn down and not the fully approved loan amount, saving you money during the construction period.

  • Lower repayments. Your loan is interest only during the construction period, helping your cash flow while the work’s being carried out which is useful if you’re also having to rent somewhere else!

Disadvantages of construction loans

  • Paperwork. The lender will want to see council approved building plans and a fixed price building contract before they approve a loan, so there’s still a bit of work and expense needed before you get approval.

  • Deposit. Loan to value ratios (LVR) are typically higher on construction loans, especially if you’re an owner builder and managing the work yourself, so you may need a chunky deposit.

  • Available funds. You may only be able to pay contractors once the lender is satisfied with the progress.

  • Higher rate. The interest rate on a construction loan can be higher than the rate charged on normal home loans, though typically this reverts back to the standard rate once construction’s completed.

TIP! You may want to consider getting a small line of credit to pay urgent bills, which you can then pay down when you receive the progress payment from your lender.

There are a broad range of construction loans on the market, including Aussie’s new Aussie Optimizer Construction Loan.

Other ways to pay for a renovation

If you’re knocking down and rebuilding, a construction loan may be the way to go. But if you’re just renovating, there are other borrowing options such as extending your current mortgage, securing a line of credit loan, mortgage redraw, releasing home equity, refinancing or even a renovation personal loan (if the work isn’t structural).

A mortgage broker can help you understand the various options and work out which one suits your needs. You get experts to do the construction for you, so why not get an expert to help you work out how to pay for it?

Have you recently upgraded or rebuilt your home? What did you do and how did you finance it?

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July 28, 2014 Erin PeakLeave a Comment 

Filed Under: Money Smarts Tagged With: borrowing-strategies, construction-loan, loan-to-value-ratio

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About Erin Peak

Erin is the social media coordinator at Aussie. Born and raised in Sydney, her heart (and wallet) long to wander abroad with Amsterdam being a favourite destination. She is a cheese enthusiast, mother to a miniature Dachshund named Lionel and eternal optimist. When she's not making people laugh at inappropriate moments she's finding free stuff on the street and selling it on eBay - talk about thrifty!

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