How does a construction loan work?

by | Jul 26, 2023 | Advice & inspiration, Financing & budgeting

It’s no secret that building a new home is an expensive endeavour for anyone. One of the options available to those building a new home is a construction loan. But what is a construction loan and how does it differ from options on the market? Most importantly, is it the best option for you and your situation?

What type of loan is best for construction?

A construction loan is named for the fact that it is purposely designed and structured to suit the construction process. Rather than receiving the entire amount of a loan at once, the payments are made through the building of your home in instalments. These are often called progress payments or progressive drawdown. Until your project is complete, you’ll be in an interest-only period and the interest repayments are in correlation with how much you’ve currently borrowed (see next section for more details).

The way construction loans work is the licensed builder and contractors will be given progress payments from the lender on your behalf over the course of the construction period. During the construction process, you’ll only need to worry about interest-only repayments. Once the project (your house) is complete, the loan will revert to a standard home principal and interest payment schedule. All lenders have their own processes so make sure you’re thorough with your enquiries and know exactly what you’re agreeing to before you sign.

How does a construction loan differ from a home loan?

It’s important to understand that construction loans are different from regular home loans. A home loan is better suited for purchasing a pre-existing property and a construction loan is best suited for a construction project.

Apart from the progressive drawdown structure, the biggest difference between a standard home loan and a construction loan is how interest works. With a home loan, the interest payments apply to the entire amount of the loan because you receive the entire loan at once. Meanwhile, the interest rates of construction loans work in stages. For example, if your initial payment is say $20,000, your first interest payment only applies to this amount rather than the entire loan you will receive. As more payments are made the interest will rise.

How much can you borrow for a construction loan?

The amount you can borrow for a construction loan will depend on your own personal circumstances. Depending on your situation you may be able to borrow up to:

95% of construction cost: To get this amount you’ll need to be in a strong financial situation, including a great credit history, genuine savings and reliable income.

80% of the value of the land plus: If you’re using purchased land as equity

100% can be borrowed through a guarantor loan: This is when someone like your parents acts as a guarantor for your loan.

Am I eligible to apply for a construction loan?

The best way to find out whether you’re eligible for a construction loan is to talk with potential lenders. Some standard procedures involved in deciding whether you qualify are inspecting both the land you’re building on and evaluating your building plans

What is the maximum LVR for construction loans?

LVR stands for Loan to Value Ratio which measures the value of a property minus any deposit the party borrowing has saved. LVR is usually expressed as a percentage, for example, if you’ve saved 20% of the required amount and you need to borrow the rest, your LVR is 80%.

The maximum most lenders will go to is 80%. The maximum insured Loan Value Ratio is 95%.

How do repayments on a construction loan work?

Below is the usual payment schedule when you take out a construction loan. During the building process you’ll only need to pay interest, but once the construction is finished, your loan will revert to a typical standard principal and interest payment structure.

The payments come in stages through the construction process and in order for you to get your lender to make each payment, you’ll likely need to provide the following for each of the following stages:

  • A Progress Claim Certificate.
  • Copies of all your builder’s claims, invoices and receipts.

Initial Deposit (5% of payment)

This is the first amount of money that your lender will pay your builder which helps seal the agreement. Your builder will want this first deposit before they start any construction.

Slab (15% of payment)

The money paid here will cover the costs of your home’s foundation. This includes levelling the ground, plumbing and waterproofing and most notably, the concrete slab poured to form the foundation of your home.

Frame (20% of payment)

This is the stage where your home really begins to take shape. The framework of your home will be built, and this may include partial brickwork, trusses, roofing and windows.

Lock-up (20% of payment)

Your home will really start to resemble the final product during this stage. External walls will be installed along with doors and windows. By the end of this stage, your house will literally be able to be ‘locked-up’.

Fit out (30% of payment)

The costs that need to be covered here will include many internal fittings, features and fixtures. This includes plasterboard, part-installation of cupboards, plumbing, benches, gutters and any electrical.

Completion (10% of payment)

This final progress payment is where all remaining costs will be wrapped up, including remaining payments to builders and contractors. Final touches such as electricity, plumbing, and overall cleaning will be taken care of during this stage.

Which documents do I need to apply for a construction loan?

Due to the higher risks associated with construction loans, lenders tend to be very thorough when checking your situation. Chances are you’ll need the following documentation to apply for a construction loan.

Proof of Income: Usually your last few paychecks should cover this.

Evidence of monthly expenses and costs: This can be proved through a bank statement.

All assets in your name: This includes land, other properties, businesses, or any equity.

Any potential financial issues or liabilities: This covers credit card debts, loan debts or any financial issues.

What does a typical construction loan approval process look like?

Each business will have its own quirks and procedures, however, most construction loan approval processes will follow the following steps.


The first step is to make an application that lets prospective lenders know your situation and that you are seeking a loan. Nowadays, a lot of lenders offer an online option to lodge an application, however, you can also meet a specialist in person if you prefer.

Talk with lender

The next step is to talk to a lender about your prospective plans. This will likely be an in-depth discussion to assess your plans and situation, your financial standing, and where you are in your building process. From this discussion,

Provide documentation

To move forward with the process, you’ll need to provide documentation to assist with your claim. These documents will prove a range of things from your financial situation (or more importantly to your lender, whether you have the means to pay back your loan),

Documents you’ll likely need to supply include:

  • Two pay slips from your current work
  • Three months of bank statements
  • Evidence you have enough money for the initial deposit
  • Proof you own the land, whether it is the contract of sale or other evidence of ownership
  • A fixed-price building contract with your home builder

Final approval

Once the documentation has been accepted, your lender will let you know you’ve been approved for the loan.

Land settlement

If your land has yet to be settled, this will be when the money for your land will be provided.

Fund construction

This is where the loan will start to be paid out throughout the construction stages. See the above section for more details, or click here for information about the building process.


Once the house is complete, your local council will provide an occupancy permit that means you can legally live in your home and you’ll be able to move in.

Are there any potential risks or downsides to construction loans?

When it comes to borrowing money, particularly large amounts, there will always be conditions that could potentially come back to bite you. The possible downside of construction loans is that they do have higher interest payments than a regular home loan.

Another thing to remember is construction loans lack the same safety nets as more conventional loans. The Australian government has invested a lot into the new home buyers grant. These types of grants have a lot more safety nets to protect against difficulties and delays, both of which happen quite a lot in a big project like building a house.

The other risk is that it’s more difficult for a lender to assess a home that doesn’t exist yet, which means there is a risk that the loan won’t cover all your costs. The building industry is notorious for things running over budget and extra costs so this is worth keeping in mind. Delays can also throw a spanner in the works, both in terms of your sanity, and financial stress. Your lender will likely want to assess whether you can handle these types of hiccups.

Need help with your construction loan financing? Talk with an experienced building broker


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