What Are Construction Loans & How Do They Work?

What Is a Construction Loan?

A construction loan is a finance product that releases funds progressively as your build reaches set milestones, rather than paying out the full amount at settlement. You only pay interest on the amount drawn down at each stage, not the total loan amount from day one.

The structure differs from a standard home loan because the property you're financing doesn't exist yet. The lender assesses the land value, the builder's credentials, and the construction contract before approving the loan. Once approved, the loan account opens and funds are released in stages, usually after an independent inspector confirms that each stage is complete.

How Construction Loan Drawdowns Work

Your lender releases funds according to a progress payment schedule, which is typically broken into five or six stages. The builder invoices you at each stage, and the lender arranges an inspection before releasing the payment. Common stages include base stage, frame stage, lockup, fixing, practical completion, and final completion.

Consider a professor purchasing suitable land for a custom home and engaging a registered builder under a fixed price building contract. The loan might be structured with a total loan amount of $650,000, covering the land purchase and the construction contract. The land component is paid at settlement, and the construction portion is released progressively. After the base stage is inspected and approved, the lender releases the first progress payment. The same process repeats at frame stage, lockup, and so on until the build is complete.

You only charge interest on the amount drawn down at each stage, so if $200,000 has been released by lockup, you're only paying interest on that portion. This keeps repayments lower during construction, though most borrowers opt for interest-only repayment options during this phase to manage cash flow.

What Lenders Assess Before Approving a Construction Loan

Lenders need to see that the build is viable and that the builder can deliver the project. They'll review the land valuation, the building contract, council approval, and the builder's qualifications. If you're engaging an owner builder, expect more scrutiny and potentially higher deposit requirements.

The construction loan application process involves submitting council plans, the development application approval, and a cost plus contract or fixed price contract depending on how the build is structured. If the land is already owned, the lender will order a valuation. If it's part of a land and construction package or a house and land package, the valuation covers both components.

Lenders also check that you can service the loan once construction is complete and principal and interest repayments commence. Your borrowing capacity is assessed based on the full loan amount, even though you're only drawing down progressively during the build.

Fixed Price Contracts Versus Cost Plus Contracts

A fixed price building contract locks in the total build cost, assuming no variations or changes to the scope. The builder quotes a set price, and the progress payment schedule is divided into stages based on that total. This structure is straightforward for lenders because the loan amount is known upfront.

A cost plus contract involves the builder charging for materials and labour as they go, plus a margin. The final cost isn't confirmed until the build is complete, which makes lenders more cautious. Most lenders prefer fixed price contracts for standard residential builds, though some will consider cost plus arrangements if the builder provides detailed costings and the borrower has a buffer in place.

In our experience, professors and academics often prefer custom design builds with specific inclusions, which can push the project toward a cost plus structure. If you're in that position, expect the lender to require a higher contingency allowance and possibly a larger deposit.

What Happens During the Construction Phase

Once construction begins, the builder invoices you at each stage and you notify the lender. The lender arranges a progress inspection, usually through a third-party inspector who confirms the work is complete and meets the contract specifications. If everything checks out, the lender releases the funds to the builder or to your account, depending on the arrangement.

Each drawdown incurs a Progressive Drawing Fee, which typically ranges from $150 to $400 per inspection. Some lenders cap the total fees, while others charge per stage regardless of how many stages there are. This is worth clarifying during the construction loan application process because fees can add up if the build takes longer than expected or requires additional inspections.

You'll need to commence building within a set period from the Disclosure Date, which is the date the loan is approved and the contract becomes binding. Most lenders require construction to start within six months, though some allow twelve months if there's a valid reason for the delay, such as waiting for council approval or coordinating with other trades.

How Interest Is Calculated During Construction

Interest accrues daily on the amount drawn down, not the full loan amount. If $300,000 has been released by the time you reach fixing stage, you're paying interest on that $300,000 only. The construction loan interest rate during this phase is often variable, though some lenders offer fixed rate options on the land component or the total loan amount once construction is complete.

Most borrowers choose interest-only repayments during construction to keep costs down, then switch to principal and interest once the build is finished and they've moved in. The interest payments are typically debited monthly from your offset or transaction account, and you can make additional payments if you want to reduce the balance ahead of final completion.

Construction Loans for Renovations and Knock-Down Rebuilds

A construction loan isn't limited to building on vacant land. If you own a property and plan to knock it down and rebuild, the same progressive drawdown structure applies. The lender values the land with the existing dwelling removed, then assesses the construction contract as they would for a new build on vacant land.

Renovation finance works differently depending on the scope. Minor cosmetic work is usually funded through a standard home improvement loan or by redrawing from an existing mortgage. Larger projects involving structural changes, extensions, or adding a second storey often require a dedicated house renovation loan with progress payment finance based on a builder's quote and staged invoicing. The lender will want to see council plans, a fixed price contract, and confirmation that the works will add value to the property.

What to Know About Land and Build Loans

A land and build loan combines the land purchase and the construction contract into a single loan facility. You settle on the land first, and the lender holds the remaining funds for the construction phase. This is common when buying a vacant block and engaging a builder separately, or when purchasing a house and land package from a developer.

The deposit is typically assessed on the total package price, so if the land and construction together cost $700,000 and you're borrowing at 90%, you'll need a $70,000 deposit plus costs. Some lenders offer low deposit loans for teachers and related professions, which may also apply to construction loans depending on the lender's policy.

Quality construction matters more to lenders than speed. A registered builder with a solid track record and appropriate insurance is non-negotiable. If the builder isn't licensed or doesn't carry the required public liability and contract works insurance, most lenders won't proceed.

When to Consider a Construction to Permanent Loan

A construction to permanent loan rolls the construction phase and the ongoing home loan into one facility. You don't need to refinance or reapply once the build is complete. The lender assesses the full loan upfront, releases funds progressively during construction, then converts the loan to a standard principal and interest or interest-only facility once the build is finished.

This structure suits borrowers who want certainty and prefer not to deal with a second approval process after construction. The construction loan interest rate during the build phase may differ from the rate once the loan converts, so it's worth clarifying how the lender structures the transition.

Call one of our team or book an appointment at a time that works for you. We'll review your build plans, check which lenders suit your situation, and walk through the progress payment schedule so you know what to expect at each stage.

Frequently Asked Questions