Construction loans: how they pay your builder, what you pay while you build, and what can go wrong

What is a construction home loan?

A construction home loan is a loan that pays for a new home in stages while it's being built, instead of in one lump sum on settlement day. The lender pays your builder a set share of the contract price as each stage is finished, and checks the work before it pays.

It differs from an ordinary home loan in three ways. The money goes out bit by bit, so you owe more as the house goes up. You pay interest only on what's been paid out so far. And the lender wants far more paperwork about the build itself: the builder, the contract, the plans and the payment schedule.

How does a construction home loan work?

A construction home loan works in four steps. The lender approves the whole loan up front, against your land and the builder's contract. It settles the land, if you're buying it. Then it pays the builder stage by stage as each claim comes in. When the last stage is paid, the loan becomes a standard home loan with principal-and-interest repayments.

Before each payment, the lender sends a valuer to confirm the stage is done. Firstmac, for example, orders a progress valuation at every stage where a payment is asked for [3]. Your own money is used before the loan's: Firstmac pays any contribution of yours to the builder first, before it pays a single stage from the loan [3].

Each payment the lender makes to the builder is called a drawdown, or a progress payment. Your repayments rise after each one, because you're now paying interest on more.

What are the progress payment stages?

The progress payment stages are the points in the build at which your builder can ask to be paid. One lender whose policy Money Brain has read treats five stages as standard, and accepts up to eight [1]. Its standard schedule is below.

That lender says plainly why it checks the schedule: it's concerned about contracts that pay the builder a bigger share of the price than the share of the work done. If a builder with a front-loaded contract fails part-way, you've paid for work that isn't there [1].

What this means for you: you can lay your builder's payment schedule beside these five numbers before you sign. If the early stages ask for noticeably more than these, that's the question to raise with the builder, and with us, while it can still be changed.

How much deposit do you need to build a house?

The deposit you need to build is set by the lender's construction limit, and it's often lower than the limit for buying an established home. One lender whose policy Money Brain has read lends up to 80% of the property's value for construction [1], against up to 95% on its standard home loans [2].

That lender also measures the 80% on the lower of two numbers: the value of the finished home, or the cost to build it (land plus the contract price) [1]. So a home that's valued above its cost when it's finished doesn't lift what you can borrow. Its construction loans start at $150,000 and go up to $2,000,000 at 80% [1].

LVR, the loan as a share of the property's value, is the number every lender sets the limit on. On a $300,000 block and a $500,000 contract, if the finished home values at least at its $800,000 cost, 80% is a $640,000 loan, so you'd need $160,000 of your own money or equity, plus costs.

What this means for you: someone who's been told they can borrow 95% to buy can find they need much more of their own money the moment they decide to build instead. It's the same person and the same income, but a different limit, and it's better found out before the land contract than after.

What do you pay while the house is being built?

While the house is being built, you pay interest only on what's been paid out so far, so your repayment starts small and grows with each stage. Here's an illustration, not a client file: you owe $300,000 on the land and sign a $500,000 build contract, at an illustrative 6.5% a year [15].

Once the home is finished and the loan switches to principal and interest over 30 years, the repayment on the full $800,000 would be about $5,057 a month at the same rate [15]. If you're renting while you build, you're paying rent on top of all of this, so plan for both.

The rate itself is set by each lender and moves over time, which is why this is an illustration at a stated rate rather than a quote.

Land and construction loans: buying the land first, then building

A land and construction loan covers both the block and the build, and most lenders want both settled as one plan from the start. Firstmac lends on vacant land only when a fixed-price building contract is already in place at application, and then as one construction loan [3].

When the land settles, a small part of the building contract can be paid to the builder as their deposit. Firstmac allows up to 5% of the contract, or up to 6.5% in Western Australia [3]. The rest is paid in stages as the house goes up.

The order matters. Sign the land contract before your building contract is ready, and you can be left needing a loan for the land alone, which is harder to get, as the next part shows.

Can you get a home loan for land only?

A home loan for land only, with no building plan, is harder to get than a construction loan. The lender policies Money Brain has read tie vacant land to a building contract: Firstmac has no plain vacant land loan [4], and another lender's standard-loan route for vacant land needs a building contract too [1].

If you want to buy land now and build later, the lender question is worth settling before you sign for the land, not after. The answer depends on the lender, how much of the price you're borrowing, and what you plan to build.

Do you even need a construction loan?

You don't always need a construction loan. One lender whose policy Money Brain has read lets some builds go on a standard home loan instead, with no building contract or council plans needed for approval, no progress payments, and no lender control over when the money is paid out [1].

Its conditions are strict. The loan must be 80% or less of the property's value as it stands today, and no more than the value of the land. A licensed builder must be engaged for the structural work, and you must show the build cost so the lender can see you can finish. A property where building has already started in any form doesn't qualify [1].

For a knock-down rebuild or a vacant block, the same route is open only up to 80% of the land's value, and with a building contract [1]. In practice, it suits someone with plenty of equity or savings who wants to borrow a modest amount against the land and fund much of the build themselves.

Knock-down rebuild: building on land you already own

A knock-down rebuild, where you demolish your home and build a new one on the same block, is usually financed as a construction loan, because the lender is lending against a home that doesn't exist yet. The same stages, contract and plans apply, and the land you own counts toward your side of the deal.

What this means for you: owning the land helps, because your equity in it can cover much of what you'd otherwise need in savings. But if the block is vacant land you owned before securing a place, the 5% Deposit Scheme won't help you build on it [6]. And at one lender, the simpler standard-loan route is capped at 80% of the land's value [1].

You'll also need somewhere to live while the new home goes up, so the rent or the cost of staying elsewhere belongs in the budget from the start.

House and land package, or off the plan?

A house and land package is usually two contracts, one for the land and one for the build, and it's financed as a construction loan once the land settles. It's a new home, so it can qualify for the first home owner grants set out below, and it's an accepted property type under the 5% Deposit Scheme [6].

The catch is the title. Many packages are sold on estates before the land is titled. Under the 5% Deposit Scheme, the land must be titled within your 90-day pre-approval window, or the guarantee can't be issued [6]. Ask the developer when titles are expected before you commit.

Buying off the plan is different. You sign to buy a home that isn't built yet, usually an apartment or townhouse, and the loan is usually settled once it's finished, so you don't manage progress payments to a builder yourself.

First home owner grants when you build a new home

First home owner grants are mostly paid for new homes, so building is often where a first home buyer gets the most state help. Each state sets its own amount and price limit:

The ACT helps through stamp duty rather than a grant, and the Northern Territory sets its own terms; both are on their own pages. A grant is usually paid at settlement or, on a build, at the first progress payment, not when you sign, so don't count it toward the deposit you need up front. See first home buyer grants for every state.

How much can I borrow to build a house?

How much you can borrow to build comes down to the same things as any home loan: what a lender counts of your income, your debts and your living costs. Banks then check you could still make the repayments if rates were 3 percentage points higher, the buffer APRA has set for lenders [14].

Building adds two limits of its own. The lender's construction limit, 80% at one lender, measured on the lower of the finished value and the cost to build [1]. And the cost of carrying two homes at once if you rent while you build, which lenders and your budget both have to absorb.

So your borrowing for a build can come out lower than for a purchase at the same price. See how much can I borrow for how the income side is worked out.

Is construction loan interest tax deductible?

Construction loan interest is not tax deductible on a home you'll live in. On an investment property, it generally can't be claimed while the home is being built either.

The ATO says the costs of holding vacant land, including loan interest, generally can't be claimed, and land with a home under construction stays "vacant" until the home can lawfully be lived in and is rented or available for rent [5]. In practice, that means after the occupancy certificate.

This is general information from the ATO's own page, not tax advice. How it applies to you is a question for your accountant.

• ATO, deductions for vacant land

Cost overruns and variations: who pays?

Cost overruns and variations are usually paid by you, not the lender. The loan is set against the contract price, so anything added after it, a changed kitchen or a bigger slab, generally comes out of your own pocket, and the lender will want it paid before the next stage is released.

Firstmac goes further. It keeps back enough of the loan to finish the build, as its own valuer estimates the cost to complete, whatever the payment schedule or the building contract says [4]. If its valuer thinks finishing will cost more than the money left in the loan, you can be asked to cover that gap before the next payment.

Leave a buffer above the contract price, and avoid variations you can't pay for in cash.

What happens if your builder goes broke?

If your builder goes broke part-way, your loan stays in place, what's already been paid stays owing, and the home has to be finished by a new builder, usually at a higher price. It's the event people building fear most.

That's why payments are tied to finished stages: so you haven't paid far ahead of the work. It's also why lenders look hard at contracts that front-load payments [1]. Each state runs its own home building insurance or warranty scheme for this situation, so check what your contract and your state's scheme cover before you sign.

What if the build runs late?

If the build runs late, some lenders charge for it. Firstmac's construction period is 12 months from settlement, and if the home isn't finished by then, it adds 0.50% a year to the construction rate [3]. On a $600,000 build, that's about $3,000 a year for running late [15].

Delays happen for all sorts of reasons: weather, trades, materials, council. Ask your builder for a realistic timeline in writing, compare it with your lender's build period before you choose the lender, and plan for it running over.

Can you get an owner builder loan?

An owner builder loan, where you manage the build yourself instead of hiring a licensed builder, is the hardest construction loan to get. The lender policies Money Brain has read refuse owner-builders outright [1][3], and the 5% Deposit Scheme doesn't accept owner-builder contracts either [6].

Without a licensed builder and a fixed-price contract, a lender has no firm price and no one contracted to finish, which is the risk construction rules exist to manage. If you're set on owner-building, the questions are which lenders take it and how much of your own money they'll want, and those are worth settling before you buy the land.

What happens when the build is finished?

When the build is finished, the final payment is made, and the loan becomes an ordinary home loan with principal-and-interest repayments. Firstmac needs a certificate of occupancy before it releases the final payment [4].

Some finishing touches can be yours. At Firstmac, an owner-occupier can finish the driveway and landscaping themselves, at their own cost, with reasonable written quotes, as long as the valuation covers those items. An investment build must be a full turnkey contract, ready to live in the day it's handed over, so an investor can't finish the driveway themselves [4].

During the build, don't plan on splitting the loan or redrawing from it: Firstmac doesn't allow either on construction loans [4]. Once it becomes an ordinary loan, those features are a question for the lender's standard product.

Renovating, or building a granny flat?

A big renovation can be treated as a construction loan. One lender assesses any renovation as a construction loan when it's relying on the value of the home once the work is done [1]. The size of the job doesn't decide it; whether the lender needs the finished value does.

A granny flat has its own page, and so does renovating with the loan you already have: see granny flat finance and home loans for renovations.

What does a broker cost you?

How a broker is paid, and the rule Money Brain holds against it, is set out in full on its own page: what a mortgage broker costs.

Your first move

You've read how the money moves and where it can go wrong. The one question left is which lender's rules fit your land, your builder's contract and your timeline, and that's what Money Brain works out before anything goes to a lender.

When you're ready, the closing section below is the simplest way to start.