A construction loan has a purpose of protecting both you and your lender in the situation where there may be a default in finances.
When Renovation Becomes Construction
There often comes a tipping point when the renovation planning starts small (perhaps we are talking about a simple kitchen and a bathroom upgrade) but it can soon turn into a way bigger project – with structural changes, new rooms, a new story added. Be cautious – once your aesthetic or cosmetic changes become structural changes – then any borrowing that you require for the renovations will need to be done as a construction loan (assuming the home you are renovating is the security property).
So why is this? The reason is because your home is what your lender is using as security for the loan. The last thing the lender wants is a home that is half renovated if you run out of money because that sort of property is very difficult for anybody, including a lender, to sell. So, the construction loan protects the lender (and also you) from the situation where there are not enough funds to complete the construction.
A construction loan has advantages and disadvantages. The disadvantage is that you generally have less flexibility once the building contract is agreed upon. You must have a fixed price building contract from your builder as lenders won’t accept a cost plus builder’s contract. This is because they want to avoid surprises. The total cost has to be known upfront.
Construction loans can be more expensive. This is because each time the builder sends an invoice for payment – (this is known as a drawdown) – the lender will send out a valuer to confirm that the work that the builder has said he has done has actually been done. This comes at a cost which the borrower ultimately is expected to pay. The upside of this however is that you can feel confident that you’re not paying the builder for work that hasn’t been done. It is your money after all.