How a Construction Loan Works: Guide for Melbourne First-Time Buyers

Building a home from scratch in Melbourne as a first-time buyer is an exciting journey, but the financing side of things can feel a bit overwhelming without the right support. A construction loan, different from your regular home loan, involves unique processes like progress payments and varying loan terms.

This is when a mortgage broker can be crucial. An expert broker can guide you through each step to find the right construction loan for your plans and budget. From snagging the best rates to explaining each phase, having an expert makes all the difference.

Now, let’s break down exactly how construction loans work and what you can expect throughout the construction period.

What is a Construction Loan?

A construction loan is a short-term loan used to cover the costs of building a new home or undertaking a major renovation. Unlike a traditional home loan, which provides the full loan amount upfront to purchase an existing property, a construction loan releases funds in stages as the construction progresses.

This means you only draw down what’s needed at each step of the building process.

The key difference lies in the structure of repayments and how the loan is drawn down. With a standard mortgage, your repayments start immediately on the full loan balance. 

However, with a construction loan, repayments are usually interest-only during the build, based only on the amount drawn, not the entire loan. Once construction is complete, the loan generally transitions into a regular home loan.

In essence, a construction loan provides flexibility to match your building costs while keeping your repayments manageable during the construction period.

How Construction Loans Work

Now that we know what a construction loan is, let’s dive into how it actually works. 

Unlike a regular mortgage, construction loans are structured around the building process, with payments made in stages as your home progresses. This approach ensures that funds are released based on the completion of specific construction phases.

Key Stages of a Construction Loan

1. Loan Approval & Planning: After choosing a licensed builder and finalising your detailed building plans and contract, you'll apply for the construction loan. The lender will assess your credit score, proof of income, and conduct a property valuation.
2. Progress Payments During Construction: Instead of receiving the full loan upfront, the lender releases funds in stages directly to your builder as work is completed. These stages typically include slab, frame, lock-up, and completion. During this time, you generally make interest-only repayments based on the amount drawn down.
3. Completion & Loan Transition: When construction wraps up, your loan usually transitions into a regular home loan with principal and interest repayments. Some loans automatically roll over, while others might require refinancing to a standard mortgage.

Types of Construction Loans

Not all construction loans are the same. Here’s a quick look at the options available:

• Construction-Only Loan: A short-term loan for the build period. Once complete, you'll need to pay it off or refinance into a standard home loan.
• Construction-to-Permanent Loan: Combines the construction and standard mortgage in one package. It automatically converts to a traditional home loan once construction is done, requiring only one approval process.
• Owner-Builder Construction Loan: Specifically for those who wish to act as their own builder. These loans have stricter lending criteria, as they carry more risk due to the borrower overseeing the construction process.

Understanding how construction loans work and the different options available can help you make informed choices as you move through the building stages.

The Stages of Construction & Payment

Now, let’s break down the stages of construction and how payments work throughout the process. 

With construction home loans, funds are released in stages, known as progress payments, which align with each phase of your home build. This approach ensures that you're only paying interest on the drawn funds while the construction progresses.

1. Slab or Base Stage: This is the foundation phase where the slab is poured, and the base of your home is set. The first progress payment is typically around 10-15% of the total loan amount.
2. Frame Stage: The frame of your home is erected, including walls, windows, and roof trusses. Another payment is released, often 15-20% of the total loan.
3. Lock-Up Stage: At this stage, the home is “locked up” – meaning all external walls, windows, and doors are installed. This stage typically involves a progress payment of around 20%.
4. Fixing Stage: The interior is fitted out with plumbing, electrical, plasterboard, and other essential fixtures. A progress payment of roughly 20-30% is usually disbursed at this phase.
5. Completion Stage: The final touches are added, including painting, installations, and landscaping. The last payment is made, covering any remaining building costs.

Throughout these stages, your repayments are generally interest-only based on the drawn balance, making it easier to manage finances as the build progresses. Once your home is completed, the loan transitions to a standard home loan with regular repayments.

Are Construction Home Loans Ideal in Melbourne’s 2024 Property Market for Homeownership?

Construction home loans can be a smart choice for first-time buyers in Melbourne’s current property market. With property prices rising steadily, building your home can be more cost-effective than buying an existing one. 

According to CoreLogic, Melbourne’s property prices have been on a steady incline, with growth averaging 3.9% annually as of early 2024. This makes the construction of a new home a viable option to build equity quickly while personalising your space.

Why Construction Loans are Beneficial in 2024:

• Potential Cost Savings: By choosing to build, you may avoid paying a premium on established properties. This allows buyers to lock in a construction price early, which can be advantageous as property values continue to rise.
• Tailored for First-Time Buyers: The staged payments of a construction loan align with the construction timeline, which means repayments start small and grow only as each phase is completed. This is beneficial for first-time buyers who need to manage cash flow during the building process.
• Investment Potential: Building a home in developing or growing suburbs of Melbourne can offer strong investment potential. Areas like Cranbourne, Tarneit, and Wollert are seeing growth in housing demand as per Domain, offering the opportunity for higher future returns.
• Customisation & Value Addition: A construction loan allows you to design your home from the ground up. Unlike buying an established home, where renovation costs can add up quickly, building allows you to add value in a more controlled way.

With Melbourne’s property market remaining competitive, construction home loans can provide a pathway to homeownership and investment in 2024, especially for those who wish to build their dream home without the immediate price pressures of buying an existing property.

Case Study: A Real Melbourne Construction Loan Journey

Meet Sarah & Tom, First-Time Builders in Melbourne 

Sarah and Tom had been saving for years to build their dream home in Melbourne. They partnered with a licensed builder, finalised their construction contract, and got their construction loan application approved by their lender. Here’s how their journey looked:

• Loan Amount: $600,000 
• Loan Approval & LVR (Loan-to-Value Ratio): 80% with Lenders Mortgage Insurance 
• Progress Payments: As each stage of the building was completed, the lender disbursed funds. Sarah & Tom paid interest-only repayments on the drawn-down loan balance. 
• Completion & Loan Transition: Once the house was completed, their construction loan transitioned to a regular mortgage with principal and interest repayments.

Sarah and Tom’s experience shows how crucial it is to plan your finances, understand each stage of the loan, and ensure your builder is reliable.

Steps to Apply for a Construction Home Loan

Applying for a construction home loan is quite different from applying for traditional mortgages. The process involves understanding the stages of construction, working closely with your builder and a mortgage broker, and having the right documents prepared. Let’s walk through the key steps.

1. Choose Your Type of Loan

Before starting, decide on the type of loan that fits your needs. Do you need a construction-to-permanent loan, a renovation loan, or perhaps a building loan? Different loan products have varied features, so it's important to match one to your financial situation and project scope.

Pro Tip: Compare construction loan rates from different lenders, as rates for construction loans can vary significantly from those for traditional mortgages.

2. Prepare Detailed Construction Plans & Building Contract

Lenders require a detailed outline of the entire construction project. This includes construction plans, cost estimates, and a fixed-price building contract. Be sure to include all construction stages, the progress payment schedule, and any expected additional costs.

Pro Tip: Your progressive drawdown payments are based on the progress payment schedule within your contract. Clear plans and contracts can make this process smooth.

3. Calculate Construction Costs & Additional Funding

Understand the construction cost and account for the cost of construction including materials, labor, and internal fittings. Also, factor in any additional costs such as permits, council fees, and potential variations from your original plans.

Pro Tip: Always add a buffer for unexpected expenses or cost overruns. If needed, consider equity loans or even personal loans for extra funds.

4. Submit Your Construction Loan Application

Submit a thorough construction loan application with all necessary documents, including your income details, credit history, and project specifics. Be prepared to discuss loan types, loan repayment plans, and the repayment type (typically interest-only during the build).

Pro Tip: A strong credit score and proof of steady income can improve your chances of a favorable loan agreement.

5. Set a Clear Loan Drawdown Schedule

The lender will set up a loan drawdown schedule based on your progress payment schedule. As construction moves through each phase, the lender will release funds directly to your builder to cover that stage of work.

Pro Tip: Ensure that each stage of construction is completed as per your original plans before the lender makes the payment. This will prevent any hiccups during the construction loan repayments.

6. Understand Repayment Terms During Construction

During construction, your repayments are often interest-only, which can keep your monthly payment lower until the house is completed. Once the build is finished, the loan usually transitions to a standard mortgage, and loan repayments will change to cover principal and interest.

Pro Tip: Clarify the repayment terms with your lender before signing the loan agreement to avoid any surprises later.

7. Be Aware of Closing Costs

Construction loans come with their own set of fees, which may differ from standard mortgages. These are often referred to as sets of closing costs, and they include things like lender fees, valuation fees, and legal costs.

Pro Tip: Ask your lender for a complete breakdown of closing costs upfront, so you're aware of the total fees before finalising the loan.

By following these steps, you’ll be prepared to finance your construction project effectively and get started on your building journey. A well-structured construction loan allows you to manage payments seamlessly and keep your building process on track.

FAQs

What are progress payments in a construction loan? 

Progress payments are disbursements made by the lender at different construction stages as your home is built.

How long is the construction loan term?  

Typically 6 to 18 months during the construction period, before transitioning to a regular mortgage.

Are repayments during construction interest-only? 

Yes, most construction loans require interest-only repayments on the drawn-down balance during construction.

Can I use a construction loan for a renovation? 

Yes, renovation loans are available for major renovations and work similarly to construction loans.

What’s a fixed-price contract? 

A fixed-price contract is an agreement with your builder that locks in the cost of construction, reducing the risk of cost overruns.

How does my credit score affect my construction loan? 

A strong credit history increases your chances of loan approval and helps you secure better rates for construction loans.

Conclusion

Building your dream home in Melbourne as a first-time buyer can be an incredibly rewarding experience, especially when you have the right construction loan to support your journey. 

Understanding how construction loans work and following the right steps can make the entire process smoother and more manageable. With the right guidance, you can stay confident at each stage of the building project.

If you’re ready to take the next step toward homeownership or simply want more information on construction home loans, our team at LM Connect is here to help. Get in touch today at 0423 713 362 or visit LM Connect to discuss your options and start planning for your future home!