Understanding Construction Loans and How They Work

If you’re planning to build your dream home or undertake a major renovation, you’ve probably come across the term construction loan. These loans differ significantly from traditional home loans and are designed specifically to support the unique requirements of a building project. Whether you’re a first-time builder, an investor, or simply curious, this article will help you understand exactly what construction loans are, how they work, and what to expect throughout the process.

What Is a Construction Loan?

A construction loan is a type of home loan specifically tailored for people who are building a property rather than buying an existing one. Unlike a standard mortgage, where the full loan amount is disbursed upfront, a construction loan is released in progressive drawdowns (or instalments) as the construction reaches pre-agreed stages.

These loans offer flexibility, reduced repayments during the build phase, and control mechanisms that protect both the lender and borrower from financial risks related to incomplete construction.

Why Construction Loans Are Different

The primary differences between construction loans and traditional home loans include:

• Progress Payments: Funds are drawn down in stages, not all at once.

• Interest-Only Repayments: You only pay interest on the portion of the loan that has been drawn.

• Valuation Requirements: Multiple valuations are usually required during the build.

• More Paperwork: Detailed plans, building contracts, and council approvals are typically required before the loan is approved.

  
  

Stages of a Construction Loan

The loan is disbursed based on key stages of the building process. Most lenders follow these standard stages:

1. Deposit

This covers initial work such as soil testing and preparation. It may also include securing the builder and permits. The lender may not release any funds at this stage – the deposit often comes from the borrower’s own savings.

2. Slab/ Base Stage

Covers laying the foundation, plumbing base, and sub-floor. This is the first drawdown from the construction loan.

3. Frame Stage

Funds are released to cover the building’s frame including walls, roofing, and structural features.

4. Lock-Up Stage

At this point, the external walls and roof are complete, and the house can be locked up. Windows and doors are usually installed

5. Fixing Stage

Covers interior work like plastering, cabinetry, tiling, electrical, and plumbing fixtures.

6. Completion Stage

Final work is completed including painting, fencing, cleaning, and any minor repairs. After the final inspection, the last payment is made to the builder.

How Do Construction Loans Work?

Loan Application

When applying for a construction loan, you need to submit a comprehensive package of documentation. This typically includes:

• Signed building contract with a licensed builder

• Detailed building plans and specifications

• Council-approved plans and permits

• Proof of builder’s insurance

• Quotes for additional costs not covered in the building contract (e.g. landscaping or fencing)

  
  

Loan Assessment

The bank will assess your financial situation, just like with a regular home loan. In addition, they will conduct a valuation of the proposed completed home based on your submitted plans.

Loan Approval

Once approved, you’ll receive a loan offer outlining the terms and stages of funding. Your loan will be set up with a construction facility, allowing drawdowns as the build progresses.

Progress Payments

As construction progresses, your builder will issue invoices at each stage. You submit these invoices (and possibly a lender inspection report) to your bank, which then releases funds directly to the builder.

Interest-Only During Construction

Most construction loans are interest-only during the build. This means you only repay the interest on the amount drawn down, not the full loan amount. Once the build is complete, the loan typically converts to a standard principal-and-interest home loan.

Benefits of a Construction Loan

1. Cash Flow Flexibility

Paying interest only on the funds you’ve used can significantly ease financial pressure during construction.

2. Stage-Based Control

Because lenders only release funds after certain stages and inspections, you and the lender maintain better control over the project.

3. Tailored for Construction

Construction loans are designed specifically for building, offering features and flexibility that standard home loans do not.

4. Progress Valuations

Regular valuations help ensure that the home is being built to plan and that you're not paying for work that hasn’t been done.

What to Watch Out For

1. Delays and Cost Overruns

Construction rarely goes exactly as planned. Weather, supply shortages, or builder issues can cause delays and lead to additional costs.

2. Loan Limits

If the cost of your build goes up but your loan was approved based on original plans, you may need to fund the shortfall yourself.

3. Interest Rate Fluctuations

If your loan is on a variable rate, your repayments during and after construction can change depending on market rates.

4. Lender Requirements

Lenders can be very strict with paperwork. Missing documents or delays in valuations can hold up progress payments, which may delay construction.

Owner-Builder Loans

If you’re thinking of building the home yourself (as an owner-builder), be aware that many lenders either won’t finance these projects or will impose stricter conditions.

To qualify for an owner-builder construction loan, you typically need:

• Extensive building experience or qualifications

• Council-approved plans

• A detailed budget and timeline

• A significant deposit (often 30–40%)

These loans are considered higher risk because there is no fixed-price contract with a licensed builder, making it harder for lenders to assess the project cost.

How to Increase Your Chances of Approval

• Choose a Reputable Builder: Lenders prefer builders who are licensed, insured, and experienced.

• Have a Fixed-Price Contract: This limits the risk of budget blowouts and gives the bank clarity.

• Save a Solid Deposit: A 20% deposit will put you in a strong position and may help you avoid Lenders Mortgage Insurance (LMI).

• Use a Mortgage Broker: An experienced broker can help match you with the right lender and streamline the process.

• Ensure All Documentation Is in Order: Missing documents delay approvals and payments.

  
  

Construction Loan Example

Let’s say you plan to build a $700,000 house and have a $140,000 deposit (20%). The bank agrees to lend you $560,000.

Here’s how your repayments might look during construction:

Stage	Cumulative Drawdown	Interest-Only Repayment (at 6.5%)
Slab	$70,000	~$379/month
Frame	$150,000	~$812/month
Lock-Up	$280,000	~$1,516/month
Fixing	$420,000	~$2,270/month
Completion	$560,000	~$3,033/month

Note: This is a simplified example. Exact repayments vary depending on your interest rate, drawdown schedule, and lender policies.

Tips for a Smooth Construction Loan Experience

• Stay in Close Contact with Your Builder and Broker: Good communication ensures everyone is on the same page.

• Set a Contingency Budget: Having extra funds to cover unexpected costs can prevent financial stress.

• Understand the Fine Print: Know when interest-only ends, what fees are charged, and what happens if construction is delayed.

• Don’t Overextend: Just because you’re approved for a large amount doesn’t mean you should use it all.

  
  

Final Thoughts

A construction loan can be an excellent way to bring your dream home to life, but it’s important to understand the responsibilities and risks that come with it. With proper planning, expert advice, and a clear understanding of the process, you can confidently move forward with your building project.

By working with a qualified mortgage broker and a reputable builder, and by staying engaged throughout the construction process, you’ll give yourself the best chance for a smooth and successful experience.

Need Help With a Construction Loan?

If you’re considering building a home and want expert guidance through the loan process, Etairos Finance can help you navigate lender policies, access competitive rates, and make the entire process less stressful. We specialise in helping you secure tailored construction finance that suits your goals.

Get in touch today to discuss your project and start building your future.