Construction loans: What are they and how do they work?

A construction loan is a type of loan for those who plan to build their own home, rather than purchase an established property. It differs from a traditional mortgage in that it allows you to progressively draw money from the loan throughout the construction process, while only paying interest on the amount you use.

How does a construction loan work?

Rather than paying out a lump sum at the outset, your bank will make funds available to you in instalments as your home is being built. These instalments are known as ‘progress payments’ or ‘progressive drawdowns.’

As your builder moves through each stage of construction, they will provide you with an invoice which must be signed and forwarded to your bank or broker. Once processed, the bank will release funds to pay the builder for the work that has been completed.

Throughout this period, interest will only be calculated against the amount of money that has been drawn down so far. So if you’ve drawn $100,000 on a $300,000 loan, interest will only be charged on that $100,000.

Once construction of your home is complete and the final progress payment has been made, you will switch from making interest only repayments to principal and interest repayments. Your contracted loan term (e.g. 25 years) will also commence at this point.

Source: Niko Iliakis

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