House & land construction loans

In the context of a house and land package acquisition, we need to look at the land acquisition followed by the construction loan. They can be done separately but it makes a lot more sense to organise them together to give the purchaser certainty about obtaining finance.

Most lenders offer products that cater for house and land packages.

How does financing work when it comes to building a new property? How does it differ to financing for established properties?

Financing a house and land package is usually done in 2 steps:

Step 1: Acquisition of land.
This is a standard real estate transaction.

Step 2: Construction of the house.

Essentially a construction loan is a variable loan where funds are drawn down in stages based on the progress of the construction. Typically there are 4 or 5 drawdowns and typically these are:

  • Deposit (before construction starts)
  • When concrete slab (or flooring) is laid
  • When walls are erected
  • When the house can be secured – also called lock-up stage
  • On completion

The difference with financing an established property lies in the 2-step process described above and the progressive drawdown of the construction loan. In financing an established property, there is only a single transaction.

Also, note that during the construction period the loan is interest only. Once completed this will revert to principal & interest repayments unless the buyer initially applied for an interest only period.

Finally, although it is not directly finance related, stamp duty is much cheaper on a house and land package acquisition compared to an established property, because stamp duty applies to the land component only. This can save tens of thousands of dollars from the acquisition costs. Also, depreciation is maximised as the house is new and therefore cash flow is much better. This makes a house and land package quite attractive in the current market.

Lender's requirements

Let’s look at the 2 steps from a lender’s point of view:

In a nutshell, when financing a house and land package, a bank/lender will initially require:

  • An application form for the whole package (land and construction) and supporting documents to assess the client’s serviceability and that the client has enough funds to complete the transaction.
  • Contract of sale for the land.
  • Fully documented fixed term building contract. This includes detailed site drawings and comprehensive list of inclusions.

This will allow the lender to organise a valuation of the property as if it was completed, even though it does not yet exist. Once satisfied, the bank/lender will formally approve the whole package.

Detailed analysis of a land and construction loan

STEP 1: Land Acquisition

All parties then concentrate on settling the land first.

For land settlement, banks will require more documents such as land titling, which the conveyancer or mortgage broker usually organises.

Banks will then work out settlement amounts.

Did you know?

When calculating how much they will lend to a buyer, banks will look at the whole package and will require the buyer to contribute their share of the whole financing at land settlement. As an example, if the package is $400,000 ($150,000 land and $250,000 house) and the buyer borrows 80% overall, the bank will expect the buyer to contribute the other 20% (ie $80,000) when the land settles. In this case the bank will make $70,000 available for the $150,000 land settlement and the buyer will have to contribute the rest ($80,000 + stamp duty if applicable + fees).

The good news is that the bank will then pay for 100% of the construction drawdowns, so that the end position is 80% borrowed, 20% buyer contribution (plus costs).

STEP 2: Construction loan

The bank/lender will then turn to the construction.

Before the first drawdown is approved, a bank will ensure that all council approvals are in place, that the builder has the relevant insurance, etc.. Once they are happy that all the paperwork is in order, they will certify the file as ready for drawdown.

  • Drawdowns on construction occur upon claims being issued by the builder and after the borrower approves it.
  1. In practice, first drawdown is a deposit required by the builder, usually 5%. The builder sends a claim form (usually in the bank’s format) to the borrower for approval and this is sent directly to the bank (or the mortgage broker) for processing. Subsequent drawdowns follow the same procedure and amounts claimed must be in accordance with the building contract drawdown schedule.
  2. Banks will usually only do a site visit before they authorise the last drawdown to ensure that the house has been completed according to plans. Note: Some lenders still check the site before each drawdown.
  • During the construction, interest rates are usually variable, although some rare lenders offer fixed rates during construction.
  • The buyer pays interest on the drawn balance of the facility and some lenders charge a higher rate during the construction period.
  • Banks will want construction started within a certain period, usually 1 to 2 years. However, in practice construction should start within 3 months, or the buyer may lose the unconditional approval of the loan. If the buyer waits for, say, 12 months before starting construction, then the bank/lender reserves the right to send the file back to the credit department and check the clients serviceability again.
  • Once the construction is completed, the entire packaged loan (land and construction) becomes one standard loan. At this point the client has the option to fix the loan, usually at no cost.

What are the most important things to consider with construction finance?

As explained above, financing a house and land package is a bit more intricate than a standard loan. Therefore, use a broker who is competent with these products! There is a vast array of construction loans out there with many different quirks, and limiting yourself by going directly to a bank is not the best way to do it. Also keep in mind the following:

  • Some banks/lenders may charge a higher interest rate during construction.
  • Drawdown procedure can be painful with some lenders.
  • Fees vary between lenders.
  • Deadlines for building can vary substantially.
  • The building contract (for the construction loan) needs to be a complete fixed contract. A bank will not lend if the contract is only for an incomplete build – for instance if the buyer wants to complete part of it himself to save some money.

Do most banks and lenders offer construction loans?

Most of the banks and lenders offer construction loans, as a construction loan is essentially a variable loan with drawdown features.

Overall, there are great deals for constructions loans in the market place. A buyer (or broker if one is used) needs to do a bit more researching than for standard loans as they are more intricate.

What should first time buyers be cautious of when financing a new property?

  1. They should work out how much the property will cost overall, as they will need to finance stamp duty, conveyancing fees, mortgage application fees, etc... Stamp duty should be cheaper than buying an existing property as it only applies to the land portion.
  2. Buyers should ensure that finance is unconditionally organised for the whole package, not the land first and the building second. This could lead to surprises if the lender does not value the house at the contract value.
  3. Buyers should ensure the contract has all the necessary inclusions. Typically, blinds are not included in standard contracts, so if the buyer wants to have them financed by the banks, they should be included in writing in the contract.
  4. It is advisable to ensure that construction starts in a timely manner, especially if mortgage insurers are involved. Usually, unconditional approval is valid for 3 months, but once the land has settled, more time is allowed. In practice, everyone’s interest is to start construction quickly, but it is worth keeping the timing in mind.
  5. During the construction phase, banks/lenders will require monthly payments of the interest on the portion of the drawn down loan. Buyers will need to budget for this, especially if they are buying the property as an investment property as there is no rent coming in during construction, only interest outgoings.
  6. Don’t go on holiday during the construction period! A buyer will be required to authorise drawdown payments, so he/she needs to be contactable at least by email and will need to scan approved invoices.