How Does Construction Financing Work?

The price of residential property is constantly rising in the major cities of Australia. Consequently, the demand for construction financing is also increasing as people are looking for cheaper alternatives. Construction loans or financing serves as a substitute option to build your dream house. However, it is important to know what construction financing is and how does it work.

What is Construction Financing?

Buying a furnished house and building a property are two completely different things. Construction financing is used for renovation purposes or to construct a home. It is a specialised lending option for individuals who are renovating or building a house, as it facilitates them in successfully completing the entire construction process. This financing option is available as a construction finance or home loan with construction facility.

Why is Construction Financing Complicated?

It is not easy to build a house. In fact, it is a very complex process with the involvement of multiple stakeholders.

The following are the key stakeholders involved in the construction of a home:

  • Solicitors
  • Contractors
  • Builders
  • Lenders
  • Quantity Surveyor
  • Accountants
  • The Council

There are so many parties involved in the process, which can be quite challenging at times. For example, it is quite likely that one expert may not be able to understand the field of the other party. This can lead to errors and complications.

A large number of financial institutions and mortgage brokers are not familiar with construction at all. As a consequence, there are a number of challenges in construction financing, including approval of incorrect loan amount and delay in loan disbursement due to constantly changing requirements.

How does Construction Financing Work?

Construction financing is different from a regular home loan. For regular financing, a person receives a lump sum loan at the date of settlement. Whereas, in construction financing, a person receives progress payments from financial institutions at various stages of construction.

Stages of Construction

There are a typically five progress payments at different stages, including:

  • Slabs poured
  • Frame up
  • Completion of brickwork
  • Lock up
  • Practical completion

Using an Independent Valuer

Some financial institutions or banks hire an independent valuer who verifies whether the work has been completed at the standard or not. The next payment is released only when the valuer provides verification of the work. This can be an effective measure to evaluate the progress of work.

Determining the Loan Value

Banks need a copy of a tender or a building contract, and the construction plans along with the loan application. The valuer assesses the value of a property after completion and also calculates the estimated loan value.

The loan value represents the lower of the two:

  • On completion value, or
  • Land price plus construction cost

Additional Documents Required from the Builder

Once the builder starts receiving the progress payment after loan approval, he needs to provide the following documents:

  • The final plan approved by the council
  • Insurance plan
  • Drawdown schedule

How Does a Bank Pay the Builder Directly?

You can ask your bank to send progress payments to the builder. For example, once you receive an invoice from a builder:

  • Complete the drawdown request form and sign it.
  • The form and invoice are sent to the construction department of your bank.
  • The bank may need a valuation to verify the completed work.
  • Your lender releases further payment to your builder within five business days.

The same process is repeated at every stage of construction.

Payment Mechanism

The progress payments are also called the drawdowns. A person is liable to pay interest on the drawdown amount. For example, you get a loan approval for $300,000. However, you only draw $50,000 at the beginning. This means you are only required to pay the interest due on the drawdown amount until you draw further amount.

At the time of construction, the borrower only pays the interest as loan repayment. This provides comfort by reducing financial burden during a stressful period.

You can either convert the loan into two options, i.e.

  • principal and interest, or
  • you can continue to keep it as interest only.

This, however, depends on the lender and financing option you avail.

It is very important to know the mechanism of construction financing and how it works. It allows you to prepare a good plan and have all the documents ready, along with doing a good estimate of the overall cost.

Chat to our team at Hunter Galloway now about organising your construction finance now, call us on 1300 088 065 or email [email protected]