Embarking on a construction project, whether it's renovating your current house, adding to your investment portfolio, or creating your forever home, is a thrilling journey. The financial aspect however in the current market, can be a bit daunting! In this guide, we'll provide the step by step breakdown of just how construction loans work.
Understanding Construction Loans
A construction loan is a financial product tailored to help you manage the costs associated with building or renovating a property. Unlike a traditional mortgage where you receive a lump sum upfront, a construction loan operates on a progressive drawdown basis. This means that you access your loan funds in stages, known as "Progress Payments," alongside your builder as they complete each “stage” of the project.
The stages are generally broken down into these payments:
1. Deposit Stage
2. Base Stage
3. Frame Stage
4. Lock-Up Stage
5. Fixing Stage
6. Practical Completion Stage
The names are self-explanatory, but each of these is an integral part of the project that the builder will need to complete first, in order to get paid for that stage.
Before the build starts: To secure a construction loan, you'll need to apply with a lender just like a normal loan. Once you're approved, you'll receive an agreed-upon loan amount.
From there, you need to ensure that the lender is ready to pay your builder when the invoices start rolling through. You'll need to submit the building permit, stamped building plans and any extra variations that you have made to your build contract since it's been signed.
Your lender wants to know that you have sufficient funds to pay for the build, so if there's a difference between the build contract and the loan amount (known as a shortfall), you'll then be expected to pay this value to your builder before the bank will release any money. The bank will only want to hold enough money to finish the build, so your money will always go in first before the banks.
During the build: Unlike a traditional mortgage where you draw down your loan in full on day one, a construction loan operates on a progressive drawdown basis. This means that you access your loan funds in stages, known as "Progress Payments," as your builder completes various phases of the project.
Completion: When the last invoice is issued, the bank will complete an inspection to ensure the works are complete. While this is happening, this is your chance to arrange the insurance for your home. Evidence of this, along with the Occupancy Permit provided by your builder is required for final payment. Then after the payment has cleared to the builder, you can collect your keys.
The Benefits of Progressive Drawdowns
The concept of Progress Payments offers several advantages for individuals pursuing construction projects:
Cost Management: By disbursing funds in stages, you only pay for completed work, reducing the risk of overpaying your builder throughout the construction.
Lower Initial Interest Payments: During the construction period, the loan operates on an Interest Only basis. This means that you're only obligated to pay interest on the portion of funds that you've drawn, rather than the entire loan amount. Because of this, your initial interest payments are notably lower compared to borrowing the full amount upfront.
Embarking on a construction project is significant, and having a clear understanding of construction loans can significantly ease the stress at your end to focus on the more important things!
Remember, it's crucial to work closely with your broker, lender and builder to align the financial aspects with the construction timeline. With the right assistance, you can turn your vision into reality and create the property you've been dreaming of.