Construction Loans – what exactly are they?

So you have decided to invest in a house and land solution or lay buy you next investment.

It’s an exciting time that’s for sure. From selecting a suitable plan, choosing a builder, going through a myriad of details before signing on the dotted line, there is so much to do. (Of course you could just let our Property Advisors do the hard work for you but that’s another story)

Naturally, you’ll need a Construction loan? What exactly are they? How are they different to normal loans? How do they work?

Let me provide a simple explanation to put you at ease and describe how we take the pain out of construction loans.

First of all, it’s best to understand that a construction loan is not going to happen without your input. It isn’t a case of let me know when it’s finished. You have an ongoing responsibility to sign off each step and provide your monetary contribution to the build. You are also responsible to confirm that the construction work being claimed has indeed been done. Obviously if you are building a home you will live in, your enthusiasm for checking out the quality of the work will be higher than if it is an Investment property. But the responsibility still remains.

Most house and land purchases have two contracts, one for the vacant land and another one with the Builder. Naturally, house and land packages purchased through IDPA have the additional advantage of adhering to our Value Criteria formula to maximise future growth potential. The land contract will describe when settlement of the land will take place, while the Builders contract will deal exclusively with construction of the dwelling. It will contain lots of legal jargon covering a variety of different situations and it can seem quite complex, especially when you are going over each and every page. You may wish to get legal advice.

The Contract will also describe the way the builder will be paid, typically called Progress payments. These payments are set dollar amounts, usually 4 or 5 in number, that are due at various parts of the build. For example, when the frame is completed or when the slab or footings are done. These payments are represented by a percentage of the contract price. The builder will do the work and invoice you for the completed stage. In effect you are only ever paying for work that has been completed. You check the work is done and advise the Lender, if you have borrowed of course, to authorise them to pay the invoice. This process is called a drawdown. The Lender will get the property inspected by a valuer before the first drawdown to confirm that the project has started and then valued again before the final payment to verify it has finished.

The builder will want to be paid quickly to support his cash flow because he has already paid for the materials. With that in mind, the invoices will have a 7 day payment requirement so it’s best to move quickly when you receive one.

Most lenders will insist on applying a variable rate during the construction stage and most likely interest only will be required. Because the loans are interest only you only pay for the money you use. For example, if the first drawdown is $20,000 then you only pay interest on the $20k until the next drawdown. If the frame goes up next and the builder requires another $35k for that part of the process, then once the Bank pays the invoice your loan goes from the initial drawdown of $20k to $55k once the $35k is paid. This process continues until the dwelling is complete and the loan has been fully drawn down.

Some Lenders will increase the interest rate while the Construction phase is taking place and reduce it once it’s finished while others will charge a fee for each progress payment. These charges are a reflection of the greater level of internal administration required from the Lender.

Finally, lenders deal with the “funds to settle” or “borrower contribution” amounts differently. This figure is the money you have to put in to complete the purchase and it’s usually described in percentage terms. For example if you borrow 80% LVR your contribution would be 20% plus the purchase costs such as Stamp Duty etc.

Some Lenders will require you to put your 20% contribution for the total project in at land settlement. Others will require only the 20% plus purchase costs of the land at settlement; the remaining amount is contributed when the Builder starts construction. Only when your contribution is paid to the builder will the Lender agree to drawdown the loan for any progress payments. Naturally, it’s wise to keep the receipts from the Builder to prove payment has been made when you want the Lender to start paying.

To demonstrate how this works, let’s look at both of these methods using a common scenario.

$400,000purchase price of $200,000 for vacant land and $200,000 for a building contract
$10,000purchase costs (Stamp Duty etc.)
$410,000total required to purchase
$320,00080% LVR loan
$90,000your contribution

Scenario 1 All in at land settlement

$200,000vacant land purchase price
$10,000purchase costs (Stamp Duty etc.)
$210,000required to settle on land
$90,000less your contribution
$120,000comes from your loan of $320,000

This method leaves $200k from the $320k loan to cover the construction cost 100% but requires you to put all of your money in at land settlement.

Scenario 2 Staggered contributions

$200,000vacant land purchase price
$10,000purchase costs (Stamp Duty etc.)
$210,000required to settle on land
$50,000less your contribution ( 20% of the land = $40,000 plus purchase costs $10,000 )
$160,000required to settle (comes from the $320,000 loan leaving $160,000 for the build.)

This transaction sees the land settle and only a portion of your money is required at settlement. The next phase is when building commences.

 
$200,000required for the build
$40,000your contribution ( = 20% of the $200k Building contract)
$160,000required to fund building (comes from the remaining undrawn loan funds)
 

Your contribution may cover all, or part, of the first progress payment but either way no loan funds would be drawn down until your $40k has been paid.

(What is the interest payment differential between the 2 scenarios)

You can see that the total contribution remains the same but each scenario requires different amounts at different times. It’s the same result, only different.

When the final drawdown is requested the Bank will want to see a Certificate of Occupancy to confirm the building is complete. They will also do an inspection of their own. Around this time you should be provided with an opportunity to inspect the property by the Builder before taking possession.

No matter what, you will always have to put your money in first, BEFORE the Lender advances any of the loan funds. They will control the construction loan so there is enough money left to finish the build to protect themselves in case anything goes wrong.

As you can see, the process is more involved than a simple property purchase and the Construction Loan products available reveal how each Lender sees the markets potential for profit. It’s also instructive to know that there are some Lenders that will not do any construction loans at all.

Sound complicated?

Well, I guess it is if you have never done one before. Luckily for you, we do them all the time and can take the pain out of dealing with all the various parties involved while the build comes together.

For more information on Construction Loans or for a comprehensive review of your portfolio book an appointment now with one of our experienced Mortgage Brokers.

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