How does a construction loan work?

If you are building rather than buying an established home, you will use a construction loan, and it works quite differently from a normal mortgage. Understanding the staged payments, the interest only period during the build and the on completion valuation is what separates a smooth build from a stressful one. Here is how it works.

Money is released in stages, not all at once

The defining feature of a construction loan is that it does not hand over the whole amount at the start. Because the home does not exist yet, the loan releases money to your builder in stages, called progress payments or drawdowns, as each part of the build is completed. So the loan is paid out piece by piece, matched to the progress of construction, rather than as a single lump sum.

The typical build stages

A standard build is usually broken into around five key stages: the slab or base, the frame, lock up, fixing, and completion. As your builder finishes each stage, they issue an invoice, and once the lender is satisfied the stage is done it releases that payment to the builder. You authorise the invoices, which keeps you in control of the money flowing out.

You pay interest only on what has been drawn

During the build, you are charged interest only, and only on the portion of the loan that has actually been drawn down so far, not the whole loan. Early on, when little has been drawn, your interest is low. As more stages are funded, the interest grows toward the full amount. This is explained in more detail in our guide on interest only payments during construction.

The on completion valuation and your deposit

A construction loan is secured against the value of the finished home, assessed on completion, as if it is built, rather than just the land as it stands today. The valuer typically provides both a land only value and an on completion value, and your loan to value ratio is worked out against that on completion figure. This is also why a valuation shortfall is a risk to understand before you sign.

You generally need a fixed price contract

Most mainstream lenders require a fixed price building contract from a licensed builder before they will fund a build. The reason is simple: with a fixed price, the lender knows the total cost and can calculate how much to lend. Cost plus arrangements, where you pay the builder actual costs plus a margin, are not accepted by most lenders because the final cost is unknown. Our fixed price building contract guide covers what that means for you.

What happens after the build

Once the final progress payment is made and the home is complete, the construction phase ends and the loan typically converts to the repayment type you chose at the start, usually principal and interest. At that point your standard loan term begins and you start paying down the balance, just like any home loan.

Inspections and insurance along the way

The lender may arrange a valuation or inspection at stages to confirm the work has been done before releasing funds, which protects you as well as the lender. You will also need the right insurance in place during construction, and before the final payment is released the lender generally needs proof the completed home is insured, so a home insurance certificate is provided with the final drawdown.

Knock down rebuilds and land you already own

A construction loan is not only for new estates. If you already own a block, or love your neighbourhood but have an old home, a construction loan can fund a knock down rebuild, demolishing the existing house and building a new one. Because you already own the land, the structure of the finance can be a little different, and a broker can explain how it works for your situation.

Budget for variations and surprises

The contract price is rarely the final amount you spend. Variations you request, and provisional or prime cost allowances that come in higher than estimated, can add to the cost. It is wise to keep a sensible cash buffer above the contract price so a few changes or surprises do not derail your budget. Keeping a buffer is one of the simplest ways to build without stress.

Why construction lending needs a specialist eye

Construction loans have more stages, more documents and more lender policy variation than a standard purchase, and timing the land, the build and the drawdowns matters. A broker who knows construction lending can keep the moving parts aligned and steer you to lenders whose construction policies suit your build, which removes a lot of the friction.