Construction Loans Explained: How Finance Works When You're Building a Home
01 Jun 2026
Why Construction Loans Are Structured Differently
When you purchase an established property, the lender advances the full loan amount at settlement and takes security over the property immediately. A construction loan cannot work this way because at the time of the loan approval, the property does not yet exist in its completed form. The lender needs a mechanism to fund the build progressively while maintaining adequate security at each stage.
The solution is a progress payment structure. The lender agrees to fund the full construction cost, but releases that money in instalments (called progress draws or drawdowns) corresponding to specific stages of the build. This protects the lender (funds are released only as value is created), the builder (they receive payment for completed work), and in principle the borrower (undrawn funds do not accrue interest).
Construction loans are typically interest-only during the construction period. Once the final stage is drawn down and the certificate of occupancy is issued, the loan converts to a standard principal and interest loan for the remainder of the term.
The Standard Progress Payment Stages
Most residential construction contracts in Australia use five standard progress payment stages, though the exact split varies by builder and state. The borrower draws down funds after each stage is completed and certified.
| Stage | Description | Typical % of Build Cost |
|---|---|---|
| Deposit | Paid to the builder at contract signing, covering materials and mobilisation | 5–10% |
| Base / Slab | Foundations laid and slab poured | 10–15% |
| Frame | Structural frame erected and roof frame in place | 15–20% |
| Lockup | External walls, windows, and doors in. Property is secured. | 20–25% |
| Fixing | Internal fitout: plasterboard, cabinetry, fittings, fixtures | 20–25% |
| Practical completion | Build complete, final inspection passed, keys handed over | 10–15% |
The specific percentages in your building contract may differ from these indicative figures. Before drawing down at each stage, the lender typically requires an invoice from the builder and may conduct an inspection or valuation to confirm the stage is genuinely complete.
Land and Construction: How the Finance Works Together
Many borrowers are purchasing vacant land and building in one combined transaction. The finance for land and construction is usually handled as a single loan, but the two components settle differently. The land component settles first, just like a standard property purchase, and the construction component is drawn down progressively as the build proceeds. The land forms the initial security for the loan, with the construction value progressively increasing that security as the build advances.
If you already own the land outright or have a separate mortgage on it, the construction loan can be structured separately. In that case, the lender assesses the land value plus the end value of the completed dwelling when determining how much they will lend for the construction component.
Valuation: The End Value Problem
Lenders assess a construction loan based on the projected end value of the completed property: what it will be worth once the build is finished. This valuation is completed at the time of loan approval, before a single brick is laid, based on the plans, specifications, and comparable sales in the area. The lender's valuation is not always equal to your total project cost.
If the lender's end value assessment comes in lower than your combined land and build cost, you may find yourself short of the funds needed to complete the project. This is why it is important to get a thorough understanding of comparable property values in your area before committing to a build budget, particularly if you are building in an area where new builds are significantly more expensive to construct than to buy established.
Cost overruns during construction are also not covered by the original loan approval. If variations to the building contract push the total cost above the approved loan amount, you will need to fund the difference from savings or negotiate an increase with your lender, which may require a new valuation and credit assessment.
What to Watch for in a Building Contract
Before a lender will approve a construction loan, they typically require a fixed-price building contract: a contract where the final price is agreed upfront and the builder bears the risk of cost overruns (subject to any permitted variations). A cost-plus contract, where you pay the builder's actual costs plus a margin, is generally not accepted by lenders because the total cost is unknown at approval.
Variation clauses in fixed-price contracts should be reviewed carefully. While the base contract may be fixed, substantial variations, including changes you request during the build or builder-initiated changes due to site conditions, can add significantly to the final cost. These are typically not covered by the original loan and must be funded separately.
Builder insolvency is also a real risk that borrowers should understand. Domestic building insurance (formerly known as builder's warranty insurance) is mandatory in most states for residential construction above a certain contract value. This insurance provides some protection if the builder becomes insolvent or fails to complete the work, but it does not cover all scenarios and the claims process can be protracted.
Key Takeaways
- Construction loans release funds in stages tied to build milestones. Interest is charged only on the amount drawn down at any given time.
- During construction the loan is typically interest-only, converting to principal and interest once the build is complete.
- Lenders assess the loan against the projected end value of the completed property, not just the construction contract value. A low valuation can leave you short of funds.
- Lenders require a fixed-price building contract. Cost-plus contracts are not accepted. Variations during the build can add unexpected costs not covered by the loan.
- If you are buying land and building, the land settles first with the construction funds drawn progressively. Both components are usually combined into a single loan.
- Builder insolvency is a genuine risk. Ensure your building contract is with a licensed builder and that domestic building insurance is in place before construction begins.
