How do construction loans work?

Building a new home or taking on a major renovation is exciting, but the financing behind it works differently from a standard home loan. Instead of receiving the full loan amount in one lump sum, your lender releases funds in stages as the build progresses, and your repayments change as more of the loan is drawn down. 

This guide runs through what a construction loan is, how the stages and progress payments work, whether you’ll need a deposit, and what to have ready before you sign a building contract.

What is a construction loan? 

A construction loan is a type of home loan designed for people who are building a new house or completing major renovations, rather than buying an existing property. 

Instead of handing over the entire loan amount in one lump sum, the lender releases funds in stages as the building process progresses. Each release aligns with a stage in your fixed-price building contract, from the concrete slab through to the final inspection.

This structure protects everyone involved in the build. Your licensed builder gets paid for completed work rather than a promise of future work, and you avoid paying interest on funds that are still sitting in an account rather than being spent on building costs. 

It’s a sensible system, though it does mean the loan process looks quite different from a straightforward property purchase.

Construction loans can fund a new build on vacant land, a knockdown rebuild, or a substantial structural renovation. They’re generally not the right fit for cosmetic updates like new benchtops or a coat of paint, since these don’t usually follow a formal progress payment schedule. 

The biggest practical difference between a construction loan and a standard home loan comes down to timing. With a regular home loan, you make principal and interest repayments on the entire loan amount from day one. With a construction loan, you only start paying on money that’s actually been handed over to your builder, which is one reason people find them easier to manage while a build is underway.

The five stages of construction and how progress payments work

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Most lenders release construction loan funds across five stages, sometimes six, depending on the lender and the building contract. These stages typically run:

1. Slab stage: site preparation, footings and the concrete slab are poured and certified
2. Frame stage: the timber or steel frame, including roof trusses, is erected
3. Lock-up stage: external walls, windows and external doors are fitted, along with the roof, so the property is weathertight
4. Fixing stage: internal fittings and fixtures go in, including plasterboard, cabinetry and plumbing fixtures
5. Completion: final payments cover site clean up, painting and the finishing details that get your home ready for occupation

Your builder submits an invoice once a stage is finished, and the lender typically arranges an inspection before releasing that portion of the loan. This is why the first progress payment usually lands once the slab is down, while the final progress payment isn’t released until after the final inspection.

The amount released at each stage should match the progress payment schedule set out in your building contract. In New South Wales, this schedule sits within the Home Building Act 1989, which caps deposits and sets rules for progress claims on residential building contracts over $20,000.

Getting familiar with these stages before you start makes it much easier to plan your cash flow through the build.

Do you need a deposit for a construction loan? 

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Lenders generally still want to see a construction loan deposit, and normal lending criteria around your financial situation still apply. How much you’ll need depends on the lender, the expected value of the finished home, and your own savings.

Many of the same options available to standard home buyers also apply here. If you’re building your first home, the First Home Owner Grant offers $10,000 towards a newly built home in New South Wales. It’s typically paid at the first progress payment rather than at settlement. 

Combined with other government grants and your own savings, this can go a long way towards reducing what you need to find upfront.

If you already own land or have equity in an existing property, that can sometimes count towards your deposit instead of cash savings. Our brokers compare lenders across our panel to find a construction loan deposit structure that suits your financial situation, rather than assuming one figure fits everyone. 

Keep in mind that some lenders assess construction loans slightly more conservatively than those for an established property, since there’s no finished home to appraise until the build is complete. This is where an experienced mortgage broker can help, comparing which lenders on our panel take a more workable approach to your deposit and overall financial situation.

How loan repayments work during the construction period

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During construction, most lenders offer interest-only repayments rather than principal and interest repayments. You only pay interest on the funds drawn so far, not the entire loan amount, which keeps your loan repayments lower while you’re likely still covering rent or your current mortgage.

As each stage is completed and more of the loan amount is drawn, your interest payments increase slightly, since interest is calculated on a larger balance each time. 

Once the final progress payment is made and your builder hands over the keys, the loan usually converts to standard principal and interest repayments for the remainder of the contracted loan term. Your loan’s interest rate at that point depends on the lender and market conditions, so it’s worth checking in with your broker as completion gets closer.

This interest-only period is one of the main reasons people choose a construction loan over funding a build with savings or a personal loan alone. It’s designed to match your repayments to what you’ve actually borrowed at each point, not the eventual size of the finished home.

What you’ll need to apply for a construction loan

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Before you apply for a construction loan, lenders want to see a complete picture of the build, not just your income and savings. Typically, you’ll need:

• Council approved plans and detailed building plans for the property
• A fixed price building contract with a licensed builder, rather than a cost-plus arrangement
• Proof of the builder’s public liability insurance
• Confirmation of the expected value of the finished home, usually through an as-if-complete valuation from a property appraiser

Lenders use that final valuation, alongside your income and financial situation, to determine your maximum loan amount and whether the numbers stack up against normal lending criteria. 

Fixed-price contracts are preferred because they protect both you and the lender from unexpected building costs partway through the project.

If you’re planning to manage the build yourself, owner-builder loans are available but tend to come with tighter lending criteria, since the lender is taking on more risk without a licensed builder overseeing the project. 

Whether you’re building an owner-occupied home or an investment property, our brokers can talk you through which lenders on our panel offer construction loans to suit your circumstances. 

Other FAQs about construction loans

How do construction loans work if I want to be an owner-builder?

Owner-builder loans work the same way in terms of progressive drawdown and construction stages, but lenders apply stricter lending criteria because there’s no licensed builder taking responsibility for the project. We can talk you through which lenders on our panel consider owner-builder applications.

What’s the difference between interest-only and principal and interest repayments during a build?

Interest-only repayments during the construction period mean you’re only paying interest on the funds drawn so far, keeping your repayments lower. Once construction is finished, most loans switch to principal and interest repayments across the remainder of the contracted loan term.

Can I get a construction loan for an investment property?

Yes, construction loans aren’t limited to owner-occupied homes and can also fund a new build or major renovation on an investment property. Your expected rental income and the property’s value will factor into how much you can borrow.

How long does the construction period usually last?

This depends on the size and complexity of the build, but most residential builds take between 6 and 12 months from the first progress payment to the final inspection. Delays with materials, weather or council approvals can extend this, so it’s worth building some buffer into your plans.

Do I need a fixed price building contract to apply for a construction loan?

Most lenders prefer a fixed price contract because it locks in your building costs and reduces the risk of the project running over budget. Some lenders will consider cost-plus contracts, but normal lending criteria tend to be stricter in that case.

What happens if building costs go over the fixed-price contract?

A genuine fixed-price contract should protect you from most cost increases, but variations, site conditions, or changes you request partway through can still add to the final bill. It’s worth keeping a buffer in your own savings, in addition to your construction loan deposit, in case extra costs come up during the build.

What happens once the final progress payment is released?

Once the final progress payment is released and the occupancy certificate is issued, your construction loan converts to a standard home loan with principal and interest repayments. This is a good time to check whether your loan’s interest rate and features still suit your financial situation, or whether it’s worth reviewing your options.

Getting help from a Watson Mortgages home loan specialist

Construction loans involve more moving parts than a standard purchase, from the progress payment schedule to the final valuation, and it helps to have someone who understands the process guiding you through it. 

We compare construction loans across our panel of 30-plus lenders, so you’re not stuck with whatever your regular bank happens to offer.

Our brokers, Gary Gilbert and Nestor Ramirez bring more than 60 years of combined experience to every client conversation, and our service is completely free to use. We’re always happy to help wherever you’re building, so get in touch with our team to talk through your construction loan options before you sign a building contract!

Disclaimer

Watson Mortgages Pty Ltd (Nestor Ramirez Credit Representative Number 378816 and Gary Gilbert Credit Representative Number 432216) is authorised under Australian Credit Licence 389328. Watson Mortgages Pty Ltd ABN 29 642 538 967 is a separate entity to Elliot Watson Financial Planning Pty Ltd. Elliot Watson Financial Planning Pty Ltd is a Corporate Authorised Representative of RI Advice Group Pty Ltd, ABN 23 001 774 125 AFSL 238429. This article provides general information only and has been prepared without taking into account your objectives, financial situation or needs. We recommend that you consider whether it is appropriate for your circumstances and your full financial situation will need to be reviewed prior to acceptance of any offer or product. It does not constitute legal, tax or financial advice and you should always seek professional advice in relation to your individual circumstances.