Home Loan

What is the difference between a construction loan and a regular home loan?

As a prospective homeowner, you will find yourself navigating the many financial options to turn your dream home into a reality. Two common options that play an important role in this process are construction loans and regular home loans. 

Both serve distinct purposes, tailored to the specific needs of the buyer. Understanding the differences between these two options and unpacking their features will help you decide which option might better suit your needs. Plus, with the help of a finance broker in Sydney, you will be guided through the complexities of securing the right loan.

Construction Loans

Construction loans are designed for buyers looking to build a new home from scratch or undertake substantial renovations on an existing property. Sometimes referred to as a building option, a construction loan pays out in stages, giving you the funds to pay your builder throughout the construction stage of your home or at each stage of renovation. 

One of the main distinctions of construction loans is that loans are drawn down in stages (rather than paid out in one lump sum), and that borrowers pay interest only on the part of the loan that has been drawn, rather than the full amount. As your builder begins a new stage, a new amount is paid out. This process is sometimes known as a progressive drawdown or progress payments.

This can help as it minimises the financial burden during the construction phase when you are not using the full loan amount. However, you must remember that the interest accrued during construction will gradually increase as more money is paid out.

Another advantage of the progressive drawdown system is that it ensures you do not draw more than you need.

Some lenders have stricter requirements and terms for construction loans, requiring detailed council plans and permits, proof of insurance, building timelines and project breakdowns. This is to ensure the feasibility of the project. You will also need to ensure your builders are registered and have builders insurance. 

Generally, lenders will require a valuation of the property before they give you the loan. This ensures the lender gives you a loan that is proportionate to the value of the property. Even if this is not a requirement, it is important to remember that construction can be somewhat unpredictable and you should be prepared for cost overruns during the project. If this happens, you should speak to your finance broker in Sydney who may be able to provide advice on covering these extra costs.

In most cases, a deposit will be required to secure construction loans. This is often based on the loan-to-value ratio, meaning your deposit will likely need to be 20% of the value of the home. But, some lenders will allow construction loans to be taken out with a lower deposit as long as you take out lenders’ mortgage insurance to cover the risk of possible default.

Once the construction is complete, you’ll transfer to a traditional home loan or pay off the construction loan in full. If you go with the former, your lender may require a new valuation of the home to calculate the terms of your new mortgage.

Regular Home Loans

Home loans or mortgages are the more traditional finance option for purchasing existing property. This can include a house or apartment. Home loans are structured to provide you, the buyer, with a lump sum amount to cover the property’s purchase price. Unlike construction loans, the entire home loan is paid out upon settlement of the property and you start your monthly payments immediately based on the full amount and interest.

Interest rates for a mortgage can be fixed or variable. This gives you the flexibility to choose based on your financial situation and preferences. A fixed-rate loan uses a consistent interest rate throughout the fixed-rate period, protecting you from interest rate increases. Variable-rate loans are influenced by interest rate hikes or drops, potentially meaning your monthly payments will change from time to time as the interest rate fluctuates. Choosing between the two depends on your individual financial preferences, how open you are to risk and your financial circumstances.

Key differences between Construction Loan and Home Loan

Using the loan

Where regular home loans are used to purchase an existing property, construction loans are designed for people building a new home or doing major renovations to an existing home.

Accessing the funds

Regular home loans are paid out as one lump sum to cover the cost of the home. Construction loans are paid out in stages to cover the phases of building activities.

Paying the interest 

A regular home loan accrues interest on the full amount and can be a fixed-rate mortgage or variable-rate mortgage. A construction loan accrues interest on only what has been paid out thus far.

Gathering required documentation 

While both types of loans will require proof of income and creditworthiness, lenders will generally also need plans and permits, insurance, project breakdowns and timelines for construction loans.

Taking out a loan for your New Home

A construction loan can be a great option for a buyer looking to build a new home from scratch or wanting to significantly renovate an existing property. The requirements to secure construction loans are slightly more stringent than regular home loans with lenders requiring proof of the viability of the building project. But the progress payment system is a great option to help stretch your money a bit further by not having to pay interest on the full loan amount. 

A regular home loan can be an excellent choice if you are wanting to buy an existing dwelling, as long as you are able to prove your income and creditworthiness to a lender and secure a loan that suits your needs and means.

Working with a finance broker in Sydney, whether you are starting a building project or buying an existing home, you will be guided through the process. 

Loan Station is an experienced finance broker in Sydney that is an expert in construction loans. Get in touch today to discuss your needs.

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