Using Land as Collateral for a Construction Loan: A Complete Guide

If you own a vacant plot of land and want to build a new home on it, you may need to take out a construction loan. Unlike conventional mortgages, construction loans provide financing in phases to pay builders as the home is built While most lenders require a down payment, some allow you to use the land itself as collateral for the construction loan.

Using land as collateral can be an effective strategy but also comes with risks. In this comprehensive guide we’ll look at how land collateral construction loans work, their pros and cons, and what to consider before choosing this route.

What is a Construction Loan?

A construction loan provides financing to build a new home. The loan is disbursed to the builder in draws as certain phases of construction are completed. For instance, 10% on signing, another 20% when the foundation is poured, etc.

Since the home doesn’t exist yet, lenders need collateral for the loan. This is often in the form of the land you plan to build on plus a down payment, usually 10-20% of construction costs.

Once the home is finished, the construction loan converts to a conventional mortgage used to pay off the builder loan. You’ll then make regular principal and interest payments like any home loan.

Can You Use Land as Collateral?

If you already own the lot you want to build on, some lenders allow using this land as collateral in place of a cash down payment. This route leverages your existing equity to finance construction.

By putting up the land as collateral, you’re pledging it as security on the loan. If you default, the lender could potentially take possession and sell the land to recover funds.

Lenders will appraise the land to determine its current market value. They then lend a percentage of that value, often 50-80%. The exact percentage depends on factors like your finances, credit, and the land itself.

How Does It Work?

Here are the key steps involved in using land as collateral for a construction loan:

• Find a lender – Not all lenders offer this type of financing, so you may need to shop around. Credit unions and smaller community banks are more likely to do land collateral loans than major banks.

• Get land appraised – The lender will order an appraisal to establish current market value. Be prepared to pay an appraisal fee.

• Apply for the loan – You’ll need to provide financial documents like tax returns and bank statements to prove your creditworthiness.

• Lender evaluates property – They will consider factors like land improvements, easements, boundaries, and access to utilities to determine viability for construction.

• Lender approves loan – If qualified, they will offer a loan amount based on a percentage of appraised land value. This becomes your collateral.

• Loan is funded in draws – Money is disbursed to the builder at set milestones as your home is built.

• Loan converts after completion – When construction finishes, the builder loan converts to a conventional mortgage and land lien is removed.

What Are the Pros and Cons?

Using vacant land as collateral for a construction loan has several potential benefits:

Pros

• Allows you to leverage land equity as down payment
• Avoids cash outlay upfront
• Land may increase in value during construction
• Lower collateral requirements than cash down payment loans

Cons

• Risk of losing land if you default on loan payments
• Difficult to qualify if land has no utilities or improvements
• Limit on loan amount based on strict appraisal
• Overall cost is usually higher than buying already built home

As with any lending decision, you need to think critically about your own financial situation. Using land as collateral can be an effective option, but also introduces risk.

Tips for Getting Approved

If you want to explore financing construction with land as collateral, here are some tips to boost your chances of getting approved:

• Have land professionally appraised – Don’t rely on tax assessments or Zestimates. You need a credible third-party appraisal.

• Improved land is best – Land that’s surveyed, has utilities, and is ready for building shows viability and makes for an easier appraisal.

• Get land improvements permitted – Having permits approved ahead of time shows the property is ready for development.

• Have blueprints/plans ready – Drafted building plans illustrate your home concept and construction readiness.

• Highlight land attributes – Emphasize things like location, views, boundaries, drainage, and easements that impact value.

• Check your finances – Lenders will still scrutinize your income, credit score, debts, and down payment ability.

• Be flexible on loan-to-value ratio – Accepting a lower LTV may expand your lender options if land constraints exist.

What’s Better – Land Collateral or Cash Down Payment?

Whether to put up cash or use your land equity as collateral depends on your unique situation. Here’s a quick comparison:

Cash Down Payment

• Less lending risk for bank
• Requires large cash outlay upfront
• Down payment often 20% of build cost
• Slightly lower rates may be available

Land Collateral

• Leverages existing land equity
• Avoids large cash expenditure
• Collateral value tied to strict appraisal
• Land value limits loan amount
• Overall loan costs may be higher

If you have the cash available, a 20% down payment is ideal. But for landowners with limited liquid funds, pledging the dirt itself as collateral can be a viable alternative.

Critical Questions to Consider

Before pursuing this type of financing, here are some important questions to think over:

• How much equity do you have in the land? Enough for 20% of project costs?
• What improvements exist on the property? Is the land build-ready?
• Can you afford loan payments plus construction costs at the same time?
• Are you prepared to possibly lose your land if you default on the loan?
• Will construction increase or decrease surrounding land values?
• Would you be better off selling land and buying a finished home?
• Does your builder have experience with land collateral construction loans?

Looking at all angles of the deal will help you make a prudent decision on using your land as collateral or not.

Alternatives to Land Collateral Construction Loans

Some other options besides pledging land as collateral include:

• Save up cash for down payment – Delay construction until you have 20% of costs in the bank.

• Finance down payment separately – Take out a personal loan just for the down payment portion.

• Home equity loan – Tap equity from current home to finance construction down payment.

• Purchase already built home – Buy an existing house rather than build if cash-strapped.

• Sale-leaseback – Sell land to an investor, then lease it back during construction.

• Land interest financing – Sell a fractional interest in land to an investor for cash.

• Owner-builder construction – Save costs by acting as your own GC if experienced.

Depending on your real estate holdings and financials, these may be suitable alternatives to reduce or avoid cash outlays for construction.

Using Land Equity to Finance Construction

Tapping land equity via an installment loan or line of credit is one way to fund a construction down payment. This route essentially exchanges your existing equity for cash to put toward building costs.

If structured properly, the equity loan payments can simply roll into your new mortgage once the home is completed. This avoids needing cash upfront to start construction.

However, it also introduces risk, reduces your final loan amount, and can complicate the lending process. Run the numbers carefully before pursuing this strategy.

The Bottom Line

Using vacant land as collateral for a construction loan instead of a down payment can be an effective financing technique. But make sure you understand the risks and loan limitations involved.

Pledging land equity rather than cash can alleviate short-term expenses. Yet construction lending is complex, so you want to partner with an experienced builder and lender. Analyze the deal from all angles and seek professional guidance before moving forward.