Can You Use Land as Collateral for a Construction Loan?

Construction loans allow you to finance the building of a new home. Unlike a traditional mortgage, which is used to purchase an existing house, construction loans provide funding to pay for materials, labor, permits, and other costs during the building process. Then, once construction is complete, the loan converts into a regular mortgage.

One of the most common questions homeowners have when considering a construction loan is whether they can use land they already own as collateral. The short answer is yes, you typically can use land you own free and clear as collateral for a construction loan. Here’s what you need to know.

How Construction Loans Work

With a construction loan, funds are dispersed in stages as certain milestones are met during the building process. This helps ensure the work is progressing on schedule and gives the lender more oversight and control.

During the construction phase, you’ll only pay interest on the amount dispersed so far, not the full loan amount. Once construction is finished, the loan converts to a traditional mortgage with fixed monthly payments of principal and interest.

Construction loans typically have variable interest rates, shorter terms of around 12 months, and stricter approval requirements than standard mortgages. A down payment is usually required, which demonstrates you have “skin in the game.”

Using Land as Collateral

If you already own the property where you plan to build you may be able to use it as collateral for a construction loan. This allows you to leverage the equity in your land instead of coming up with a large down payment in cash.

Lenders will want a property appraisal to determine the land’s current market value. They will then calculate the loan-to-value ratio (LTV) based on the appraised value compared to the requested loan amount. Many lenders cap construction loan LTVs at 80%.

For example if your land is worth $100000 and you get approved for an $80,000 construction loan, your LTV would be 80% ($80,000 ÷ $100,000). You would be able to build an $80,000 home without any out-of-pocket cash.

If you still owe money on the land itself, the construction loan will be a second lien behind that original loan. The lender financing your construction will want to see you have substantial equity built up in the property before approving you.

What Lenders Look For

When reviewing a construction loan application, lenders want to see:

• Detailed building plans and specifications: This allows them to accurately estimate costs. Blueprints may be required.

• Budget/cost breakdown: A detailed budget shows you’ve carefully researched expected construction costs.

• Timeline: A schedule demonstrates you and your contractor have a solid plan to complete the project on time.

• Contractor qualifications: Your builder’s experience and track record will be reviewed to assess their ability to deliver quality work.

• Your finances: This includes income, debts, assets, credit score, and down payment funds. Strong finances lower the risk of default.

Providing thorough documentation upfront increases the chances your loan will be approved.

The Pros of Using Land as Collateral

Putting up land you already own as collateral offers several potential benefits:

No need for a down payment. If your land value is enough to meet the lender’s LTV requirements, you may not need any out-of-pocket cash. This removes a major obstacle for many construction loan borrowers.

Tap your real estate equity. Instead of selling the land, you can leverage its value to finance building your dream home on the property.

Potentially lower interest rate. Putting up collateral generally lets you qualify for a lower rate than a “no collateral” loan like a personal loan.

Consolidate into one mortgage later. The construction loan can convert to a traditional mortgage when building is done, folding everything into one convenient loan.

The Potential Downsides

Using your land as collateral does involve some risk:

Possibility of foreclosure. If you default on the loan, you could lose the home and the land. The lender may force a sale to recoup their money.

Variable rates. Construction loan rates fluctuate so your costs may rise over the course of the project. This uncertainty makes it hard to stick to a budget.

Shorter repayment term. You’ll have just 12 months or less to build the home and convert the loan to a normal mortgage. It’s risky if the project faces delays.

Stricter qualifications. Construction loans have higher credit score and income requirements than standard mortgages, so you may not qualify.

Future borrowing limitations. The new lien on your property may affect your ability to tap home equity in the future.

Shopping Different Lenders

It’s wise to compare multiple lenders when applying for a construction loan. Each lender has its own qualifying standards, rates, and terms. Key factors to consider include:

• Interest rates and fees
• Loan amounts offered
• Maximum LTV allowed
• Credit score requirements
• Income documentation required
• Length of the construction term

Get quotes from national banks, local banks, credit unions, and online lenders. Ask potential lenders these key questions:

• Will you accept the land as collateral?
• What can the loan amount and LTV ratio be based on the land value?
• How much of a down payment do you require?
• What are the interest rate and fees?
• What credit score is needed to qualify?

Alternatives to Using Land as Collateral

Some other options if you’d rather not or don’t qualify to use your land as collateral:

Save up a down payment. Come up with the down payment funds through your own savings, gifts from family, etc. A 20% down payment may be required.

Take out a personal loan. An unsecured personal loan can provide funds for a construction down payment. Rates are usually higher than a secured loan.

Use a pledged savings account. Some lenders will accept funds in a savings account pledged to them as collateral instead of land.

Joint venture financing. Bring in an investor or “hard money” lender as a partner to fund the down payment or supplement your loan.

Owner-builder financing. Only purchase materials yourself incrementally during each stage of construction to avoid needing a large loan.

The Bottom Line

Using land as collateral can be an effective strategy to obtain financing for a custom home build without needing to provide a large down payment in cash. But make sure you understand the risks, shop multiple lenders, and compare all your options before moving forward. With proper planning, you can leverage your property equity to achieve the dream of building your own home.