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Once you’ve identified a property to purchase, you’ll need to decide on how you are going to finance the acquisition and subsequent renovation. There are a couple of different ways you can choose from, which I’ll outline in this article.
One thing to consider is whether any of the renovation is going to result in structural changes. Why is this important? As a general rule if there are any structural changes to the building, you’ll need a construction loan and the first two options highlighted may not be appropriate.
Option one: Mortgage with equity release
The first option is to finance the property purchase via a standard mortgage. If you are not planning on starting the renovation right away, then holding the property and commencing paying down the principal loan balance should create some equity you can use at a later stage.
What is equity? Equity is essentially the difference between the value of the property and what you owe on the loan. For example, if you own a property worth $1,000,000 and owe $500,000 on your mortgage, then you have $500,000 in equity. The lender will not let you access the full amount of equity (unless you were to sell the property and pay off the loan); however, you can usually access up to 80%. In the above example, this would mean you may be able to release $300,000 and put this towards your renovation. Some lenders will allow you to access more than 80% of the value of the property, however different limits will apply depending on the lender.
One thing to note, is if you are arranging an equity release on your loan, there is a limit the lender will allow you to borrow to put towards your renovation without having to provide additional evidence. Once you reach that threshold, the lender may request a copy of your building contract or other documentation and may even require you to revert to a construction loan.
There are different rules on offsets and redraw, which you can access freely, so it’s good to have a chat with your broker ahead of time to ensure the lending you apply for is going to be appropriate for your situation.
Option Two: Mortgage and cash contribution
Another option is to borrow a larger amount upfront for the purchase and retain more of your cash reserves to fund the renovation.
If this is an investment property, then taking out a larger loan could be beneficial in that the interest charged on your loan may be tax deductible (always check this with your accountant first though).
If you need additional borrowings to fund the renovation, then this solution may not be suitable, which brings us to the most common type of lending for construction and renovation: the construction loan.
Option Three: Construction and renovation finance
A construction loan is specifically designed to be paid out at predetermined steps or stages throughout the building process. This type of loan is usually set to interest only during the time the build or renovation takes place, then reverts to principal and interest upon completion. The process of obtaining a construction loan is as follows:
- Apply for conditional pre-approval
This will provide guidance as to how much the bank is prepared to lend you for your purchase and renovation. Once you’re pre-approved you can start serious planning. - Select an architect and/or builder You’ll need to choose an architect and/or builder and agree on a building contract. This will set out the cost, specifications, terms of construction, building inclusions and the progress payment schedule. Once agreed on you’ll need to get plans and permits approved by your local council. Note: if you decide to engage an architect, you’ll need to cover these fees separately as they aren’t included in a standard construction loan.
- Convert your pre-approval to a formal approval
Your mortgage broker will let you know exactly what’s required here but you usually supply your signed fixed price build contract, plans and specifications, and any quotes for additional items being financed as part of the construction (such as landscaping, pools etc). An “as if” valuation will be conducted at this stage to determine an estimate of what the final value will be once your construction is completed. Once approved, you’ll be able to pay your deposit to the builder (usually 5% of your building contract price) - Stages of construction and progress payments
The stages of the building process differ across each builder, but as a guide there are anywhere from five to eight stages throughout (which is when the drawdowns occur)Stages- Slab: when the foundations are poured.
- Frame: when the exterior frame/walls are put in place and may include support structures, electrics and plumbing, gutters and insulation.
- Lock Up: when the remaining windows, doors, external walls and roofing takes place. So you can “lock up” your property.
- Fit Out: this is when all the internal fixtures and fittings are installed such as lights, power points, waterproofing in the wet areas and other plumbing and electrical fixtures.
- Completion: this final stage includes painting, flooring, appliance installation, fencing and site-clean up.
Drawdowns
- Approx. 15-20% of the funds (including the 5% deposit you paid the builder).
- Approx. 20% of funds.
- Approx. 20% of funds required.
- Approx. 30% of funds required.
- Approx. 10% of funds required.
- Final inspection and move inOnce complete, you will need to provide the certificate of occupancy plus your building insurance so the lender can arrange a final inspection and ensure the build has been completed according to the approved building plan. Once they are satisfied that the build has been completed satisfactorily they will release the final progress payment. At this stage the loan will convert to a Principal and Interest loan unless you’ve organised something different via your broker and lender.
Different lenders and builders may do things a little differently, but the above will provide a general guide for the process. When it comes time to selecting a lender for your project, your mortgage broker can help you choose one that is going to best align with your plans.There are a couple of things to flagThe first is that most lenders require you to be working with a Registered Builder. The implication here is that you will struggle to obtain a construction loan if you are an owner builder, even if you are a Registered Builder yourself.The second thing to note is that you need to have a Fixed Price Contract in place with your builder.A fixed price contract means the builder agrees to cover any costs that arise above the price agreed upon in the contract. If you make any variations to the build outside of the contract, then you’ll be liable to cover them which may mean having to go back to the bank to ask for more funds.
Where a fixed price contract benefits you (and the lender) is that if the cost of materials or labour increases then you won’t have to worry about having to cover them. The builder will be required to absorb those costs.
That’s all from me for this quarter, next time I’ll cover off lending and finance solutions for those who are self-employed.
Thanks Leah! Make sure to check out Leah’s blog on Finance 101 to find out more about the lending environment and basics of mortgages!
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