Construction Loans for Knockdown Rebuild Projects

Purchasing land with a home you plan to demolish changes how construction finance works.

When you're buying a property with the intention to knock down the existing dwelling and rebuild, you're essentially asking a lender to fund two things: the purchase of the land and the staged construction of your new home. The structure differs from both a standard home loan and a straightforward land and construction package because the property already has a dwelling on it that you won't be living in.

Consider a scenario where someone purchases an older home on a 600 square metre block in Bentleigh for $1.2 million. The dwelling itself might only contribute $200,000 to that valuation, with the remaining $1 million reflecting the land value. They plan to demolish the house and build a custom design worth $800,000. The total project cost sits at $2 million, but the finance needs to be structured to accommodate the purchase, demolition, and then progressive drawdown for the build.

How Lenders Value a Knockdown Rebuild Purchase

Lenders separate the land value from the existing dwelling when you indicate your intention to demolish. They'll typically order a valuation that assesses the site value on its own, treating the old structure as having minimal or no value. This becomes your starting equity position for the construction component.

In the Bentleigh example, if the lender values the land at $1 million after discounting the dwelling, they'll assess your borrowing capacity based on that figure plus the construction cost. Your deposit needs to cover the purchase price shortfall and provide the required equity for the build. Most lenders require at least 10% deposit for the land component and will lend up to 90% of the land value plus construction costs, though some prefer 80% loan to value ratio across the whole project.

The valuation becomes particularly important in established areas like Camberwell or Canterbury, where older homes on large blocks often trade well above their improved value because buyers recognise the land potential. Lenders know this, but they'll still want confirmation that the site value alone supports your loan amount.

Structuring the Purchase and Construction Phases

Most knockdown rebuild purchases use a split loan structure. The first portion funds the land purchase as a standard home loan, while the second operates as a construction loan that draws down progressively.

You'll typically take the full amount needed for the purchase upfront, making principal and interest or interest-only repayments on that portion immediately. The construction component remains undrawn until building commences. As you reach each building stage and request payment, the lender releases funds according to your progress payment schedule. You only pay interest on the construction loan amount that's been drawn down at each stage.

This structure means your repayments increase as the build progresses. At the start, you might be paying interest on $1.2 million. By the time you've completed the slab and frame, you could be servicing $1.6 million. After final completion and the construction loan converts to a standard mortgage, you're repaying the full $2 million.

Progress Payments and the Drawdown Schedule

Construction funding releases in stages tied to your building contract. Most fixed price building contracts in Victoria follow a five or six stage payment schedule: base stage, frame stage, lock-up, fixing, practical completion, and final completion.

Before each payment, the lender arranges a progress inspection through a quantity surveyor or building inspector. They verify that the work claimed has been completed to the required standard. Only after receiving that confirmation will the lender release funds. This protects you and the bank from paying for work that hasn't been done.

Your registered builder submits invoices according to the contract milestones. The lender typically pays the builder directly, though some allow you to receive the funds and pay the builder yourself. Many lenders charge a Progressive Drawing Fee for each inspection and drawdown, usually between $300 and $500 per stage.

Timing Requirements After Settlement

Most construction loans require you to commence building within a set period from the settlement date, typically 12 months. This clause exists because lenders price construction finance based on current building costs and site values. If you delay significantly, those assumptions might no longer hold.

In a knockdown rebuild scenario, this timeline includes demolition. You'll need council approval for both the demolition and your new development application before construction finance can be drawn. In practice, many buyers in areas like Glen Iris or Hawthorn East arrange their council plans and building permits before they even settle on the purchase, ensuring they can demolish and start building immediately.

If you think you'll need longer than 12 months before starting construction, discuss this upfront with your broker. Some lenders offer extensions, while others might require you to refinance into standard home loan terms until you're ready to build, then convert back to construction funding later.

How Interest Accrues During Construction

During the building phase, you'll make interest-only repayments on whatever amount has been drawn down. This includes both the original purchase loan and any construction funds released so far. Interest compounds monthly on the outstanding balance.

The construction loan interest rate typically sits slightly higher than standard variable home loan rates because of the additional risk and administration involved in progressive drawdowns. At current variable rates, you might see construction rates sitting 0.20% to 0.50% above a lender's standard owner-occupied rate.

Once construction reaches practical completion and you receive your occupancy certificate from the council, the construction loan converts to a standard home loan. At that point, you can choose to remain on interest-only repayments or switch to principal and interest if that suits your circumstances.

What Happens If You're Building While Renting

Many people purchasing a knockdown rebuild need somewhere to live during construction. You'll be paying rent plus loan repayments on the land purchase, which affects your serviceability calculations from the start.

Lenders assess whether you can afford rent, the loan repayments on the full completed project, and any other commitments simultaneously. Even though you won't be paying the full loan amount until the build finishes, they test your capacity against that final figure. This often means knockdown rebuild buyers in Melbourne need strong household income or substantial savings to demonstrate serviceability, particularly if they're renting in the same suburbs where property costs reflect the inner and middle ring premium.

If rental costs are significantly affecting your borrowing capacity, some lenders will allow you to factor in the rent savings once the build completes, though policies vary.

Dealing With Cost Overruns and Variations

Your building contract might specify a fixed price, but variations during construction can still occur. If you request changes to the original plan or unforeseen site conditions require additional work, the contract price increases.

Lenders approve construction finance based on your original contract sum and specifications. If the cost rises beyond that figure, you'll need to cover the difference from your own funds unless you can apply for additional borrowing. Most lenders will consider topping up your construction loan if the property's expected end value supports the higher amount and your serviceability allows it.

This becomes particularly relevant in older suburbs like Malvern or Brighton East, where you might discover unexpected site conditions once demolition occurs. Asbestos removal, contaminated soil remediation, or undocumented easements can add tens of thousands to your project cost. Setting aside a contingency of at least 10% of your construction budget gives you room to absorb these costs without needing to renegotiate finance mid-project.

Moving From Construction to Permanent Finance

Once your builder reaches practical completion and you receive your occupancy permit, the construction loan converts to a standard mortgage. This happens automatically with most lenders, though the conversion often triggers a review of your loan structure and interest rate.

At conversion, you might choose to refinance to a different lender if their ongoing rates or features suit your circumstances better than the construction lender's standard product. Alternatively, you could renegotiate with your existing lender for a better rate, particularly if your property's completed value gives you a lower loan to value ratio than anticipated.

The conversion point also allows you to split your loan between fixed and variable portions, set up offset accounts, or adjust your repayment approach. Many borrowers shift from interest-only to principal and interest repayments once they move in and no longer have dual rent and mortgage costs.

If you're planning a knockdown rebuild purchase and want to understand how construction funding would work for your specific property and circumstances, call one of our team or book an appointment at a time that works for you.

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