Buying a Land and House Package? Know how a construction loan works
Buying vacant land and building a house on it is an exciting plan. People get easily sold to the idea that they would be building their dream house and the temptation is even more when the selling agent provides well-articulated pressure tactics.
Building a house is a lot more complex process than what many think. It is not only a time-consuming process but also has a high chance of litigation if not dealt with properly. The project requires ongoing involvement of several parties and when various parties are brought together, chances of getting stuffed up increase. Coordination of works among all these stakeholders and managing any imperfections are very important tasks to get the project completed on time.Who is involved in the house and land package transactions?
- Selling agent
- Your conveyancer or legal representative
- Your mortgage broker
While they all perform in their own specialized field, finance approval and progress have a significant impact on how these parties interact with each other. Among many other reasons, handling your finance can contribute to the project delay and cause a lot of stress to you.
How many loan applications will be there?
There will be two separate loan applications – one for the land and the other for construction.
Land Loan: If the land is registered already or soon to be registered (let’s say within 3 months' time), then a full approval for a land loan can be lodged. Before the bank can approve your finance formally, they need to conduct a valuation of security and the land be ready or accessible to conduct the valuation.
If the land is still going through civil works (such as road construction, drainage construction in the area etc), then the full valuation is not possible and formal finance approval cannot be done.
Construction Loan: When you have finalized the contract works and variations (if any) with the builder, we need to begin the application for the construction portion. We need to obtain the pre-assessment or even pre-approval to get an idea of whether the proposed loan amount for construction works can be supported.
What if the land valuation comes different to my purchase price?
As mentioned earlier, the valuation is organized only when the land is accessible to inspect physically. If you bought off the plan vacant land or an unregistered land, you would have to wait several months or even years to have the title registration completed. The property market can change by this time and valuation might come different to your purchase price.
If it comes higher, then good on you. We do not need to worry too much about the valuation side.
If the valuation comes short, then we have some concerns and you are left with some choices as below:
- You need to contribute extra to cover for the shortfall amount
- Borrow the same amount but the loan-to-value ratio (LVR) is now changed and you will have to pay higher lender mortgage insurance. Sometimes, borrowing may not be possible at all due to the high LVRs!
- Try other banks to see if the valuation is better from them
What happens if the loan cannot be organized for off the plan vacant land?
We need to apply for a land loan when it is within 3 months from the anticipated settlement date. Your finance approval depends on your income, saving, liability, commitment and financial characteristics position at that time. It also depends on how the property market is performing when you have applied for the loan and how much appetite lenders have in that type of transaction.
In the worst-case scenario, if you cannot get your finance sorted out when land registration occurs, you risk losing a 10% deposit you made towards the land purchase plus any litigation costs as per the contract. You also risk losing any other deposits you have paid to the builders so far.
How long will be the finance approval valid for?
Once your finance for the land portion is approved, you will have 90 days to have this matter settled. Otherwise, the loan will expire as your financial circumstances are considered to be different past 90 days. There are some lenders who can accept the settlement for a period of up to 6 months from the formal approval date.
If your approval is expired, then you need to go through all over again with credit assessment including a new valuation.
When do we apply for a construction loan?
A construction loan can be applied when you have the below documents. Please check with your builder and advise your broker whether or when these documents will be available:
- Fixed price building contract as per the industry-standard
- Floor plans and elevations
- List of specifications and inclusions
- Variations and/or additional legitimate quotes for “out of contract” items (if applicable);
If you have these documents ready at the time of signing the land contract, we can submit both applications (land and construction) for formal approval at the same time.
If these documents are not handy right now, you can ask your builder when these documents will be ready and advise the broker so that they can plan the application process accordingly.
However, you need to get your broker to pre-assess your case and check if the loan amount for proposed construction works can be supported later.
Do I need legal advice for the building contract?
Your engagement of conveyancer or legal representative ends with the settlement of the land purchase. Many purchasers enter into the building contracts by interpreting the clauses themselves and hoping that nothing untoward will happen to them!
If you are not confident handling such clauses yourself, it is advisable to seek legal advice on the building contract. You may speak to a solicitor and discuss the scope of their engagement and associated fees to determine whether you want to do it yourself or engage a solicitor for the building contract.
What is a variation and why can this occur on my building contract?
A building contract is the most complicated contract we have seen so far. While there is an industry-standard in place, the way some builders play around with the words is beyond your imagination. We have seen a lot of contracts with so many variations of the clauses.
Whenever the builder gives you a tender or quote about the building works, please make sure to ask whether below items are included in the price or not:
- Air-conditioner (ducted, split or something else?)
- Retaining walls (if applicable)
- Providing interim occupation certificate
If the above items are not included in the contract, it is important to ask for inclusion and request the amended quote.
The above works attract higher costs when you want to do it yourself. This can add up to your costs significantly later and you will be stretched financially to complete these works. If not included in the contract, banks want to see how you are going to cover for these variation works and asks for the proof that you have access to additional funds or a written undertaking that you will complete it on your own.
In addition, after the contract is signed, you will be invited by the builder for various appointments for the selection of carpet, kitchen, brick, bathroom, tile, interior color, driveway color, electricity, etc. Your base construction price will include obviously very basic items only. When you are at these appointments, you will be tempted to upgrade the quality of items and that would attract additional costs. Accumulated cost for each of these upgrade works can add up to a significant amount. If you want to include these costs in the loan application, then you need to include these variations works to the contract.
What is the Progressive drawdown on my building contract?
The building contract will have a provision for progressive drawdown into different stages as they progress with the works. When the builder completes each stage, they will ask for the payment. You will need to authorize these payments and send them to the bank/broker, who would then arrange for payment processing.
Many builders draw down their payments into six stages. There is an ambiguous clause in the industry standard that can easily cause dispute between the builder and the bank. As a result, you and the broker will suffer ultimately. It is always recommended to have the progress payment schedules been drafted in the following manner so that the drawdown is in line with the lender standard.
|Construction Stage||Expected Works||% of the total cost|
|Preparation/Deposit||Plans, permits, connection fees, insurance, driveway crossings and soil test.||Up to 20%* (Deposit not to exceed 10%)|
|Slab/Base||Concrete slab complete or footings and base brickwork complete.||Up to 20%* (Deposit not to exceed 10%)|
|Frame||House frame is complete and approved by building surveyor/inspector.||No restriction up to 90% (including Preparation / Deposit and Base)|
|Lock-up/Enclosed||Windows/Doors, Roofing, Brickwork, Insulation||No restriction up to 90% (including Preparation / Deposit and Base)|
|Fixing||Plaster, Kitchen cupboards, Appliances, Bathroom, toilet, laundry fittings/tiling Heating, Fixing/internal doors etc, Plumbing, Electrical, Painting Registered builder – to be undertaken in one stage Owner builder – can be split into two stages.||No restriction up to 90% (including Preparation / Deposit and Base)|
|Practical Completion||Fencing, Site clean-up, Supervising builder||Minimum of 10%|
You need to check the above progress payment schedules and ask your builder to amend it if necessary before you accept the tender. Requesting to change later is a time-consuming process and may not be approved by the builder in some cases!
Will there be another valuation when the construction loan is applied?
When you have finalized the building contract and variations, it is time to apply for the construction loan. As with any loan application, the bank organizes another valuation again.
Unlike your previous valuation for the land portion, the lenders want to see not only how much the current land value is but also the total value of the property when proposed building works are completed.
The valuation may come short at this stage as well. The shortfall could be due to the valuer putting a conservative estimate on recently settled land or building cost or both. Your broker will need to work alternative way outs or even refinance the application to another lender altogether if you cannot bring additional funds as a result of this valuation shortfall.
When can your builder start the works?
As soon as the land is settled in your name, the builder will organize the planning permits and approval either from the local council or a private certifier. This usually takes around 4-6 weeks. The process will also involve obtaining approval on construction designs for the structural works. The builder cannot start the job without these approvals are held on the file.
In addition, the builder will ask for a commencement letter from you. You need to obtain this letter from your broker and forward it to the builder.
What is the commencement letter?
After you have returned the signed loan documents, the bank will certify the documents and requests for any outstanding information. When they are satisfied with the paper works, they will settle the construction loan and issue a commencement letter stating that the approved loan amount is now ready to be drawn down. This gives confidence to the builder that any claim for payment will be honored on time and that there will not be any delay in payment processing.
It is very important for both builders and customers not to begin the construction works until a commencement letter has been issued by the lender in order to avoid disputes and future litigations.
How will my builder be paid?
As soon as any stage of works is completed, the builder will send you the invoice for payment. You need to complete your part of the contribution before you can ask the bank to pay from your approved loan account. Banks conduct progress inspections two times - before the release of the first payment and last payment – to make sure that claimed works have been carried out in a satisfactory completion level. The payment processing for the first and the last can take a while. Please set up your expectations accordingly.
Different lenders have different ways (and even different forms) of processing such requests. You need to speak to the broker as soon as you receive any invoice for payment. Once they guide you on how to do it, you will be set for the rest of the invoice claims.
Why are experienced brokers needed?
Please note that regardless of registration status, buying vacant land and building a house is the most complex transaction type. The project carries a lot of variables and uncertainties as you move along.
On the other hand, if you are building a house for the first the time or a first home buyer, you are considered to be having very less knowledge about property and its features.
When the least knowledgeable participant enters into the most complex transaction, then you already anticipate what could go wrong! In order to avoid the process shocks, project over-run cost blow out, the dispute with the builder and litigation, it is important that you have a clear understanding of how to finance the approval process works. If this is something you cannot handle yourself, you need to seek assistance from experienced brokers. Please note getting a construction finance approval alone can be a big challenge for many brokers when they don’t know how to approach the transaction in the first place.
Buying land and building a house should be something very pleasant experience so that you can enjoy moving into your dream home. This can be achieved if you have experienced brokers by your side who can handle the very frustrating part of this journey, which is a finance approval.
If you want to use our experience and expertise to build your dream home, please BOOK a complementary finance strategy session.Want to check whether House and Land package is right for you? Go through our quick cheatsheet.