Construction Loan.

Building loans are different to standard home loans primarily because the lender only has security over the land whilst they are asked to fund the end perceived value of the house to be built. To limit their risk of having lent out more money than the value of the asset that they hold as collateral security, the lenders do partial drawdowns of the total approved loan and typically pay the builders over five stages of the house construction once that stage has been completed. The borrower is only required to make interest payments on the portion of the loan that has been drawn down to pay the builder. The building loan always starts out as an interest only loan during construction and on completion of the home the lender converts the loan to a regular principal and interest loan.

Construction loans are drawn down gradually or paid in stages as the building is erected.  The lenders generally have 5 stages that determine when they will make payments to the builder, but these do differ slightly between lenders.  These 5 stages are:

• Foundation – earthworks and concrete slab.
• Frame up – erecting of the frame and roof.
• Lock-up – installation of windows and doors to ensure house is lockable.
• Fixing – flooring, plastering and sealing
• Completion – painting complete with appliances installed.

The lender will check up on the builder during construction by doing partial valuations of the house as it is being built.  These are done at the various stages prior to the release of funds to the builder.  This also becomes a practical form of protection for the borrower, ensuring that the funds handed to the builder were actually spent on the borrower’s proposed dwelling!

While not all lenders operate the same, you can generally expect to follow these 5 steps when applying for a building loan:

1. Talk to your broker and get your maximum loan pre-approved.
2. Start looking for land and the house you would like to build.
3. Get the land and build contract from the builder.
4. Talk to your broker to finalise your building loan approval.
5. Upon settlement of the land, you can start building.

If you purchased your land for say $550 000 and you already have a “land loan” for that land, the required repayments will be principal and interest. Now, if you are hoping to get a loan to build for $650 000 and the broker submits a fixed price contract to the lender with the loan application, then the lender will convert the repayments on the land loan to interest only.  The reason for this is to assist the borrower with the extra cashflow that will be required for construction whilst they are still either paying rent or paying the mortgage on another home.  

The lenders can only charge interest on the funds drawn down for the construction.  The first repayment is triggered when the builder makes a claim for the first progress draw upon completion of stage 1 of the construction, which typically is the base stage that includes concrete slab, footings, and base brickwork.  The bank then pays the builder, and the bank starts charging the borrower interest on those funds paid to the builder.  As each phase of the construction is completed the bank charges the interest, and the borrower is expected to make an interest only repayment.  When the loan is fully drawn, the loan converts to a principal and interest repayment.

One of the biggest challenges when building your own home is having to fund your existing mortgage or rent while paying for the construction loan. However, only the interest is required to be paid on each portion of the loan that is drawn down for each phase of the construction.  This will help your cashflow a little, but you will need to be careful with your budget if your finances are tight because builders notoriously take longer than promised!  One way to prepare yourself financially is to ask your mortgage broker if you can have your existing home loan changed to reduce your repayments to the absolute minimum.  Here are a few ways that you could achieve this:

• by converting your existing loan to interest only 
• or by extending the term of the existing home loan.  
• Or by consolidating any other short-term loans such as car loans, personal loans and credit cards, into the existing home loan which would have a dramatic positive impact on your cashflow.

Yes, you can, but you should not plan to!  Any variations to your building contract must be approved by the lender, otherwise you will have to fund any extra building costs out of your own pocket. Where there is a significant increase in funds required, and you don’t have the available cash, you will need to get the broker to relodge an application for further funds and the lender will restart the process of reassessing your eligibility for further credit.  The builder may even be required to stop work until the further funds have been approved. In other words, don’t plan on making any large changes because it can get rather complicated and become a cashflow nightmare!   

There are two main options when buying a home from a developer. The first is that the house of your choice is built on the developer’s land, and the second is that you acquire the land first and then get a builder to build on your land.

Package 1
The house of your choice is built on the developer’s land which you purchase and finance once the construction is complete.  The developers will generally insist on a non-refundable deposit for you to secure the purchase and construction.  No progress payments or further monies are expected from you until the construction is complete.  At that point you complete the purchase by making the necessary arrangements with your lenders to pay the balance of funds to the developer.

Advantages:

• Fast build – Because the developer/builder will complete the project without delay to save on interest charged by their lenders for the funds they have borrowed for the project.  The quicker they build, the less it costs them!
• Your risk of the builder leaving you with a half-finished house is minimised.  You only actually purchase the finished product. 
• You don’t pay interest on funds borrowed since the loan is not in place until you take possession.  An attractive thought if you are unable to afford the loan repayments plus existing rent.

Package 2
You choose the land you want and purchase it from the developer.  You might need a 10% deposit but that depends on how you present the loan application to the lender.  Please ask our Multi Choice mortgage brokers for assistance.  The balance of the land’s value is to be paid upon settlement of the land purchase contract, after which the builders can commence construction.

The difference here is that you take ownership of the land prior to construction.  That means you will need to pay stamp duty on the land when you transfer it into your name and will need a “land loan” to fund it, unless you can pay cash from the proceeds of a property that you have sold.  Importantly, only once you have taken ownership of the land will the lenders be prepared to release approved funds for construction.  Simply, the lenders won’t let you build a beautiful home and spend their money on land that you don’t legally own because you have no jurisdiction or legal ground to choose whether you get to live in it!  If the house is completed and then the developer does not transfer the property into your name, you will end up with a debt to the bank without a house to live in! So, in short, the lenders will protect themselves by only releasing funds for construction if they have a mortgage over the property, which will basically be protecting you. 

During construction, the bank releases funds to the builder at various stages of the construction, that is; slab down, framework erected, roof complete, flooring and tiling complete and lock-up. This protects the bank and the borrower from a ‘dodgy builder’ who doesn’t plan on spending the money on the agreed construction!

Advantages of Package 2:

• You will generally have more choice in the design of the home.
• You have more control in the finish and standard of workmanship since payment is made only if you are happy with the quality of the work.
• Stamp duty costs may be lower since you only pay transfer fees on the land component.

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You don’t necessarily need to take out a specific building loan to make renovations to your existing property provided that you have sufficient equity in the home.  However, there are two very good reasons why you would preferably use a construction loan if you were renovating your existing property.  The first is that you’ll pay a lower interest rate and, the loan will also be structured over a longer repayment period, which means that your minimum required monthly loan repayments will be much lower than if you were to fund it with a short term loan such as a personal loan.  

Secondly, the bank might insist that you use a construction loan!  That happens when you don’t have sufficient equity in the existing home to fund the renovation without relying on the increased value of the home after the renovation.  For example, if you needed $220,000 for the renovation and your existing home is valued at $800,000 and you already owe the bank $560,000, then you would not have enough equity in the home to complete the project if the home loan was increased to a maximum of 80% LVR on an as-is valuation.  Instead, you will have to get the bank to do a valuation on the proposed end value of the house after the renovation.  If the house values at the extra $220,000 with an on-completion valuation of $1,020,000, then the final LVR will be 76% which is below the required 80% level, (without having to pay mortgage insurance on the whole loan.)  The bank will then insist on controlling the loan drawdowns to make sure that their loan to you does not exceed the value of the security property as the funds are withdrawn.  The example is explained again below:

Existing loan $560k/ $800k = 70% LVR (LVR of existing dwelling before the loan)

• $640k/ $800k = 80% LVR (acceptable LVR for a new loan but with insufficient extra funds available for the renovation; $640k - $560K = $80k available when we require $220k)
• $220k + $560k/$800k = 97.5% (unacceptable bank LVR with a normal loan)
• $220k + $560k/$1020k = 76% (acceptable LVR with a building loan)

  If you do have sufficient equity in the home, then you could simply increase your existing home loan sufficiently to cover the cost of the renovation and then control the payments to the builder yourself.  This will of course, make the whole process simpler for you.