A good client of mine recently asked if they could have a line of credit in order to bulldoze their existing house and build a new one – they wanted to manage the build themselves. The answer was no – and virtually all lenders I am aware of under almost all circumstances will say no to that proposal. It’s not that they want to make more money out of a construction loan – it is simply that they want to control how and when it is disbursed.
So the primary difference between a construction loan and a normal home loan is that the lender controls the outlay of funds rather than a single lump sum payment into an account. When you think about it, with the number of builders and developers who go broke every year it is understandable that the lenders require this. The process is called ‘progress payments’ ie: the builder puts in an invoice claim for payment when he achieves specific milestones in the construction work. The lender will probably send someone out to have a quick (or thorough) check to ensure that everything is as it seems and the pay the builder.
Unlike a standard term loan which is fully drawn at settlement your construction loan starts with a zero balance and then gradually increases as the progress payments are made. This means that you are only paying interest on the balance at any given time rather than on the full loan amount. In addition most construction loans are ‘interest only’ during the construction phase and this means you don’t start paying any of the principal off until the construction is over.
As a result of the extra administration and inspections most construction loans come with a higher interest rate (often the full standard variable) and /or additional fees such as site inspection fees for progress payments. Keep in mind that the higher interest is charged only on the current balance and only for the duration of the build – so you are not committing to 30 years of high interest rates.
Having said that there are some lenders who offer fully discounted interest rates on construction with minimal fees and even the option to fix the interest rate… well worth asking us for advice on these.
Another thing to be aware of is that if you are buying vacant land, you will be required to commit to commence (or complete) construction within 12 months. This is due to APRA regulations to avoid lending to speculative land buyers – after all they are really commercial borrowers not residential.
Finally it is important that you understand how the lender values the property for the construction loan. It would be nice if they could forecast the value based on current comparable properties – however remember they are taking the risk and so the property is not comparable until it is fully completed. Therefore they will use the purchase price or valuers estimate of the unimproved value of the land – plus the construction costs and this it. It is important that you take this into account when calculating your contribution as you have to have enough left over after your deposit to complete the items that were not included in the construction contract – although many lenders will make small adjustments, do not take it for granted – speak to your mortgage broker.