Paying for a granny flat: cash, equity and loans

Most granny flat jobs that stall don't stall on the block or the approval. They stall on the money: a loan that won't pay for a module sitting in a factory, a valuation that comes in short, or a lender who wants a document nobody asked for until the week before the deposit. This guide covers the general options and where they trip up. It isn't financial advice for your situation. For that, see a licensed mortgage broker or your lender, and we explain when below.

The three common ways to pay

Cash

The simplest. No valuations, no lender sign-off at each stage. Keep a buffer for provisional sums that run over and for the site costs people forget. Our guide to reading a quote covers those.

Equity: a top-up or a separate loan

Moneysmart defines equity as the value of your home less what you still owe on it. If you have enough, a lender may increase your existing loan, set up a separate loan split, or give you a line of credit secured against the home. You get the money up front, or draw it as you need it, and pay interest on what you use.

This suits a job where the money goes out in a few large lumps, like a modular home. It also means your home is the security, so the full amount is at risk if the job goes wrong. If you're 60 or over and thinking about a reverse mortgage or another equity release product, Moneysmart's guidance is to get independent financial advice first, because of the long-term cost.

A construction loan

A construction loan is a home loan for building. Instead of one payout, the lender pays the builder in stages as the work is done. During the build you usually pay interest only on the amount drawn so far, and the loan turns into a normal principal and interest loan at the end.

Lenders want to see a signed building contract with a payment schedule, plans and specifications, the approval (or the plans going in for approval), and the builder's insurance before the first payment. NAB lists home warranty insurance, public liability and builder's all risk insurance among its builder documents.

Progress payments: the law's stages and the lender's

Two sets of rules meet here, and they need to line up.

The law, in Schedule 1B of the QBCC Act, caps the deposit on a home building contract: 10% on a contract over $3,300 and under $20,000, 5% at $20,000 or more, and 20% where more than half the contract value is work done off site, which covers most modular homes. After the deposit, each progress claim must relate to work done at your site and be in proportion to its value.

The lender has its own schedule. Westpac's published guide, for example, caps the first stage (deposit and base) at 20%, says no middle stage should be more than 35%, and wants at least 10% held back for the final stage. Its sample five-stage schedule runs 20% base, 20% frame, 30% external lining, 20% lock-up and internal lining, 10% completion. Macquarie publishes a similar one. Before each payment the lender may send a valuer to check the stage is done.

If your contract's stages and the lender's don't match, payments stall and the builder waits. Give the lender the contract's payment schedule early and ask, in writing, whether it fits.

Why lenders treat modular, kit and owner builder jobs differently

Until the home is on your land, the lender's only security is the land. A module half built in a factory 80 km away isn't something the bank can sell if things go wrong. Commonwealth Bank says it plainly on its prefab page: the land is the sole security until the home is transported to site, and if the builder fails before the home is fixed in place, you can end up in negative equity and still owe the loan.

Some lenders now fund off-site building, with limits. Commonwealth Bank lets you draw up to 80% of the build contract price (or 150% of your land equity, whichever is lower) while the home is built, if the maker is on its assessed list, and up to 60% of the contract price or 120% of the land equity for other makers. Other lenders may not fund off-site stages at all, which leaves the deposit and factory payments to come from cash or equity.

Kit homes run into a similar wall, because a kit is a pile of materials until it's built. Westpac's owner builder rules, for one, say it won't make a progress payment for materials on site that aren't yet fixed to the building.

Owner builder jobs carry more conditions again. There's no builder's home warranty insurance, because owner builders can't get cover under the Queensland Home Warranty Scheme. Westpac will lend to owner builders, but asks for an independent adviser to cost the job and inspect every stage, owner builder construction insurance, and completion within 24 months of the loan offer. It pays out only against the valuer's cost to complete. Some lenders don't lend to owner builders at all.

We often suggest an owner builder permit for modular installs, for reasons in our owner builder guide. If you go that way, sort the finance first, because it narrows your lenders.

Valuations, and what a granny flat adds

A construction lender has the job valued before it starts, usually on the plans and contract as if it were finished, and may value again during the build and at the end. The lender picks the valuer, and the valuer works for the lender, not for you.

What a granny flat adds to your property depends on the area, the size and finish, and what similar homes nearby have sold for. A granny flat sits on the same lot as your house, so the valuer looks at the whole property, not the second home on its own. Nobody can promise you a number, and we won't. If the value matters to your plans, ask your lender or broker what a valuation is likely to show before you commit.

If you're building to rent it out, the rent counts as income for tax. That's a question for your accountant, and our guide to renting a granny flat covers the rest.

Line up the lender before you sign

1. Talk to a broker or your lender while you're still getting quotes. Tell them it's a granny flat, and whether it's built on site, modular or kit, and whether you'll be the owner builder.
2. Ask what they'll lend, how they value it, and whether they pay anything before the home is on your land.
3. Get conditional approval if you can.
4. Ask the builder to put a finance condition in the contract, so you can get out if the loan falls over. Queensland's cooling-off period is only 5 business days from when you receive the signed contract, which is too short to get a loan approved. Have your lawyer check how that condition is worded.
5. Give the lender the contract's payment schedule and check it fits theirs before you sign.
6. Keep cash for the deposit, the gap between your loan and the contract price, and the costs outside the contract (connection fees, some reports).

When to talk to a broker

If your job is modular, kit or owner built, if you're self-employed, or if you need equity from your home as well as a construction loan, a broker who knows construction lending will save you time. Moneysmart says mortgage brokers must put your interests first when they recommend a loan, should show you more than one option, and must tell you what commission they may receive. They're usually paid by the lender, and they don't always have access to every loan. Ask why they recommended the one they did.

• What a granny flat costs in SEQ
• Reading a building quote
• Owner builder or licensed builder for a modular granny flat
• Renting out a granny flat in Queensland
• How long a granny flat takes
• Get a quote