Understanding repayments in a construction loan

Understanding Construction Loans

Before delving into repayments, it’s crucial to grasp the fundamentals of construction loans. Unlike traditional mortgages used to purchase established properties, construction loans are specifically designed to finance the construction or renovation of a new home. These loans typically disburse funds in stages, known as progress payments, as the construction progresses.

How do construction loan repayments work?

Construction loans operate differently from traditional home loans used for purchasing established properties. Instead of borrowing the entire loan amount upfront, borrowers draw down progress payments as construction progresses, paying interest only on the funds utilised.

For instance, if you’ve been approved for an $800K loan but have only drawn down $150K for construction, you’ll only pay interest on the $150K. This means you avoid paying interest on the total loan amount while the property is still under construction. However, it’s important to note that no principal repayments are made during this period.

The process of drawing down progress payments involves invoicing by the builder and other trades as construction moves through various stages. These payments are typically divided into five or six stages, including deposit, foundation, framework, lock-up, fit-out, and completion.

While not mandatory, lenders generally prefer fixed price contracts before construction begins. This offers assurance that building costs won’t exceed the loan amount, reducing the risk of overcapitalisation. However, fixed price contracts have faced challenges due to rising building material costs, leading to unfinished builds and company closures.

Once construction is complete, the lender arranges for a final inspection by a valuer. 

The final payment is then drawn down, and the construction loan transitions into a principal and interest loan, marking the official start of the loan term.

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