Construction Loans: The Pros and Cons of Building

What Makes Construction Funding Different from a Standard Home Loan

Construction finance releases funds in stages as your build progresses, not as a lump sum at settlement. You draw down money at key milestones like slab, frame, lockup, fixing, and completion, with the lender arranging a progress inspection before each release. Interest charges apply only to the amount drawn down so far, which keeps early repayments lower than they would be on a fully drawn loan.

Consider a scenario where someone is building a two-bedroom granny flat with a fixed price building contract of $180,000. At the slab stage, they might draw $36,000. Interest for the first month applies only to that $36,000, not the full loan amount. By lockup, when $108,000 has been released, interest charges reflect that higher balance. This structure means monthly costs climb gradually rather than hitting you with the full repayment from day one.

Most lenders offer construction loans for granny flats with five or six drawdown stages. Some charge a Progressive Drawing Fee each time funds are released, typically between $200 and $400 per inspection. That can add $1,000 to $2,400 to the total project cost depending on how many stages your lender requires. A few lenders don't charge these fees at all, which makes a noticeable difference on smaller builds.

Progress Payment Finance and How the Drawdown Timing Works

Your builder submits a claim when each stage is complete, and the lender arranges an inspection within a few business days. Once the inspector confirms the work matches the claim, funds are released directly to the builder or into your nominated account if you're managing payments yourself. The process usually takes three to five business days from claim to payment, so builders expect that delay and factor it into their scheduling.

Problems arise when council approval or development application delays push back the start date. Most construction loans require you to commence building within a set period from the Disclosure Date, often 12 months. If your council plans take longer than expected, you may need to reapply or accept updated terms. That timeline matters particularly in areas where council approval can stretch beyond six months.

If you're working with a registered builder under a fixed price contract, the progress payment schedule is usually tied to the contract milestones. The builder can't claim the lockup payment until lockup is genuinely complete, and the lender's inspector will verify that before releasing funds. This protects you from paying for work that hasn't been done, which is one reason lenders rarely approve construction finance for owner builder projects unless you have trade qualifications and prior building experience.

Interest Rates and Repayment Options During the Build

Construction loan interest rates are typically slightly higher than standard variable rates, though the gap has narrowed in recent years. Some lenders offer the same rate for construction as they do for established property loans, particularly if you're building on land you already own with sufficient equity. Others apply a margin of 0.10% to 0.30% during the construction phase, then revert to standard rates once the build is complete and you convert to a construction to permanent loan.

During construction, most borrowers make interest-only repayment options, paying only the interest on the drawn amount each month. Once construction is complete, the loan converts to principal and interest repayments based on the full loan amount. You can also make additional payments during construction if your loan allows it, which reduces the balance before the conversion and lowers your ongoing repayments.

Some lenders let you split the construction funding across variable and fixed components, though the fixed portion usually only applies after the build is finished. That approach can work if you want rate certainty once the loan converts but need flexibility during the drawdown phase. A split loan for granny flat construction gives you both, though you'll need to confirm the lender supports splits on construction products before proceeding.

Land and Construction Packages Compared to Building on Equity

A land and construction package combines the purchase of suitable land with construction funding in a single loan. The lender assesses both the land value and the proposed build, then approves a total loan amount that covers both. You settle on the land first, then draw construction funds as the build progresses. This structure works well if you're buying a house and land package or a vacant block with plans already approved.

Building on land you already own is different. The lender values your existing property, calculates available equity, and approves construction funding based on that equity plus any cash you're contributing. If you have an existing mortgage, the construction loan can sit alongside it or replace it entirely through a refinance. Using home equity to build a granny flat is common for owner-occupiers adding a second dwelling to their title, and the equity often covers the full build cost without needing additional cash deposit.

In one scenario, a couple owned a property valued at $850,000 with a $320,000 mortgage. They wanted to build a $160,000 granny flat on the same title. The lender approved a new total loan of $480,000, refinancing the existing mortgage and releasing construction funds progressively. Their equity covered the entire project, and they didn't need to provide any cash deposit beyond covering settlement costs and the first progress inspection fee.

Fixed Price Building Contracts and Cost Plus Arrangements

Most lenders will only approve construction finance if you have a fixed price building contract with a registered builder. The contract sets out the total build cost, the progress payment schedule, and the expected completion date. The lender uses that contract to determine how much they'll lend and when each drawdown will occur. Fixed price contracts protect you from cost blowouts, and they give the lender confidence that the project won't exceed the approved loan amount.

A cost plus contract is less common in residential construction but sometimes used for custom builds or renovations where the final cost can't be determined upfront. Under this arrangement, you pay the builder's costs plus an agreed margin, and the total can vary depending on materials, labour, and unforeseen issues. Most mainstream lenders won't approve construction funding on a cost plus basis because the final loan amount is uncertain. A few specialist lenders will consider it if you can demonstrate sufficient equity buffer and the builder provides detailed cost estimates.

If you're planning a house renovation loan or a custom design where costs might shift during construction, expect the lender to apply a higher assessment buffer or require a larger deposit. The more uncertainty in the build cost, the more cautious lenders become.

What Happens After Construction Is Complete

Once the final inspection confirms the build is complete and the occupancy certificate is issued, the construction loan converts to a standard home loan. The full loan amount is now drawn, and you begin making principal and interest repayments based on the agreed loan term. If you were on a variable rate during construction, you can often switch to a fixed rate at this point without penalty. If you had a split loan arrangement, the fixed portion activates once the conversion occurs.

Some lenders require a formal revaluation at completion, particularly if the build has added significant value to the property. That revaluation can affect your loan-to-value ratio and may open up options to access further equity if the property has increased in value during construction. If the valuation comes in lower than expected, it usually doesn't affect your existing loan, but it might limit your ability to borrow further against the property in the near term.

The conversion from construction to permanent loan happens automatically with most lenders. You don't need to reapply, and the interest rate, fees, and loan features carry over from the original approval unless you've negotiated changes during the build period. The main shift is moving from interest-only payments on a rising balance to full principal and interest repayments on the completed loan amount.

Building a new home or adding a second dwelling gives you control over design, quality construction, and the final layout, but the funding structure requires more coordination than buying an established property. If you're weighing up whether construction finance suits your situation or need help comparing lenders who access construction loan options from banks and lenders across Australia, call one of our team or book an appointment at a time that works for you.

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