How do construction loans work?

Most construction loans have a variable interest rate, however there are some available that operate as fixed rate loans.

If you do use a fixed rate construction loan, you may end up with one rate on your land loan and a second, different, rate on your construction loan.

Approval for a land and construction loan is a little different to approval for an established home. Often the land and building purchase will need to settle separately. To accommodate this, your initial loan will be run as two separate but simultaneous applications, one for the land purchase and the second one for the completed house and land cost. The second application will eliminate the first loan, leaving you with just the one loan.

Most lenders will also require that you build on your land within two years of actually settling on your land. You don’t need to finish the home within the two year time frame, you just need to start within two years of settling on your land.

The construction of your home or completion of your major renovation will generally be conducted in stages, with payments required at the end of each stage. Your construction contract will detail the exact cost of the build, with the cost broken down into the payments the builder requires at each stage.

As each stage of your home is completed, the builder will invoice you for that stage. Assuming you are happy with the work, you will submit that invoice, along with an authority from you instructing your lender to pay the builder, to your lender for payment. For major construction, your lender will generally also inspect the property and may value the property at each stage to ensure you will have sufficient funds to complete the process. Once all parties are satisfied, your lender will then pay your builder on your behalf.

The bank or lender only charges you on the amount of money you have drawn down, therefore your minimum repayment will vary depending on which stage your home has reached.

Subject to finance clause
Depending on your location, land developers and builders may insert a finance clause in the contract they prepare for you. A finance clause serves a number of purposes:
  1. It takes your land/new home off the market. This is applicable predominantly to house and land packages or development projects where there are a lot of blocks for sale,
  2. It gives you time to secure formal finance approval. The process will take less time if you have already organised a formal pre-approval; and
  3. If for some unforeseen reason the lender declines your application at the last minute, the finance clause allows you to walk away from the contract legitimately and without adverse consequences.

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