Construction loans typically come with higher interest rates compared to regular principal and interest (P&I) home loans, primarily due to three main factors:

Higher Risk for the Lender: Interest rates for loans that only require interest payments are generally higher as they pose a greater risk to the lender. Since construction loans fall into this category, the increased risk contributes to the higher interest rates.

Uncertainty and Risk of Construction: Lenders face additional risks with construction loans because the property being built does not yet exist. Various complications can arise during the construction process, such as unfavourable weather conditions, delays by tradespeople, or shortages of building materials. These uncertainties increase the risk for the lender, leading to higher interest rates.

Difficulty in Determining Loan-to-Value Ratio: Assessing the final loan-to-value ratio (LVR) becomes challenging for lenders when funds are disbursed in stages as the construction progresses. Complications or unexpected costs during the construction phase could reduce the proportion of your deposit compared to the value of the completed home. This uncertainty regarding the LVR also contributes to higher interest rates.

In addition, various fees associated with construction loans may be higher, typically reflected in the comparison rate. For example, the valuation fee tends to be higher as the valuer needs to assess the value of the property at each stage of construction, as explained in more detail below.

Construction loans operate through a process called progressive drawdown, where the loan amount is disbursed gradually as various stages of the construction project are completed. Typically, construction projects are divided into six stages:

Deposit: Pay the builder to begin construction, which usually requires an upfront deposit.

Slab down: Covers the foundation of your property, the concrete base, levelling the ground, plumbing, and waterproofing foundations.

Frame: This covers the frame of the home, which can include some brickwork, roofing, trusses, and windows.

Lockup: Finish putting up the external walls, fill-in with windows and doors.

Fitout of fixing: This covers the cost of internal items such as fittings and fixtures, plasterboard, part-installation of cupboards, benches, further plumbing, electricity and gutters.

Completion: Towards the end of construction, builders and equipment and other contracted items usually need to be paid for. This part also covers finishing touches such as more electrical outlets, plumbing, additional cleaning, paint and other items.

Construction loans can be utilized for renovation purposes, although they typically require substantial renovation projects. This is primarily because lenders typically have minimum loan sizes around $150,000. Such renovations could encompass significant changes like a complete backyard remodel, including the addition of a pool, deck, and other features.

It could also involve adding another story to the existing home or extending it with an additional bedroom. If you are already repaying a home loan, your bank or lender may necessitate refinancing or converting your mortgage into a construction loan. This allows them to implement the progressive drawdown feature to disburse funds as needed throughout the renovation process.

Numerous lenders offer the option to utilize the equity you have accumulated in your current home to finance the construction of your next home. Equity refers to the value you have gained on the property (through loan repayments and appreciation) minus the outstanding balance. In many cases, construction loans require a 20% deposit, and lenders often require the equity accessed to be at least 20% of the property value.

When tapping into equity, it is essential to consider a few factors. Firstly, accessing equity reduces your financial buffer in case of unforeseen circumstances such as a downturn in the property market. Secondly, you will now be responsible for paying two mortgages, which can significantly impact your household budget. These factors should be carefully evaluated before deciding to access equity for construction purposes.

In Australia, the value of land tends to appreciate quickly, while buildings typically depreciate. As a result, a significant portion of your property's equity is likely tied to the land itself. If you own a vacant block of land, it makes sense to utilize the equity in that land for financing a home construction project.

If you have held the vacant land for a few years, you may have accumulated enough equity to fund the construction of a home on it. However, it's important to note that a vacant land loan is distinct from a construction loan, so you will likely need to refinance the loan. Most lenders permit this, but it's advisable to double-check and confirm their specific requirements. 

Construction loans typically have an interest-only repayment structure, resulting in lower payments during the construction phase. Once the construction is completed, the loan may transition into a regular mortgage with principal and interest (P&I) payments. With P&I payments, you will start paying down the principal of the loan, leading to a significant increase in your regular repayment amount. This change can be quite noticeable.

If the total duration of your home loan, including the construction phase, is 30 years, and if the construction itself takes two years, your principal repayments will be condensed into 28 years. This compressed timeframe can make the repayments appear higher compared to purchasing an established property. However, it is anticipated that the cost-effectiveness of the construction process will outweigh the expenses associated with buying an already built property.

Obtaining a construction loan requires additional steps compared to a standard home loan. Since you will be building a new property, the local council will likely require information about the construction project. In addition to applying and securing the construction loan, you will also need to apply for and obtain approval for the following:

• Council plans and permits
• Professional building plans
• Proof of land purchase
• A contract with a licenced builder
• Proof of builders insurance

After these are acquired, the lender’s valuer will proceed with their valuation. Beyond that, the usual manner of checks and balances apply:

• Good savings behaviour
• A good credit rating
• Have an adequate deposit
• Proof of employment and how you’ll repay the loan

There are a few things to weigh up when it comes to building a home versus buying an existing one, not least of which are the considerations that come with taking out a construction loan.

Pros

1. Reduced repayments: Lenders dish out money for each step, meaning you only pay interest on those amounts. The whole construction process is also usually interest-only, making repayments more manageable in the early stages than P&I repayment types.
2. Protection at each stage: Construction loans are usually broken up into six stages, with the lender and valuer assessing work at each stage. This provides some protection from dodgy tradies if say the slab is poured poorly - because there are more eagle eyes watching the work than just you.
3. Cheaper stamp duty and more grants available: Stamp duty is usually only paid on the land, not the home being built. In addition, many state governments offer additional concessions and grants if you’re building rather than buying an existing home.

Cons

1. Risks: There are a lot of unknowns that can happen when building a home - ever watched an episode of Grand Designs? Poor weather, dodgy tradies, and material shortages can all draw out the process and add to costs. Budgets can easily be blown out, and the final product might not be the one you had in your dreams when you started.
2. Higher rates and LVR: Interest rates are typically higher on construction loans because they: are interest-only, delivered in stages, and the lender assumes more risk. If costs blow out, that can also make your LVR higher i.e. reduce the proportion of your deposit.
3. Higher ultimate interest paid: If you pay IO for two years of the construction phase, and the loan then rolls over into a P&I loan, the interest paid will ultimately be greater. You’ll also face higher repayments because the principal repayment is condensed into say, 28 years, not 30 years like with a regular home loan.