can i use land as collateral for a construction loan

How to Use Land as Collateral for a Construction Loan

If you own a vacant plot of land and want to build your dream home on it using the land as collateral for a construction loan can be a smart financing option. Construction loans allow you to borrow money to pay for building costs with the land itself acting as security for the loan.

However, it’s important to understand requirements and best practices when using land as collateral for construction financing. Follow this guide to learn if it may be the right choice for your building project.

What is a Construction Loan?

A construction loan is a short-term loan used to finance the building of a new home. The funds cover hard construction costs like materials and labor, as well as soft costs like permits, fees, and design work.

Since the home doesn’t exist yet, the land is used as collateral for the loan instead of the home itself. The lender places a lien against the land, meaning they could take ownership of it if you default on the loan.

Once home construction is complete, the construction loan is typically replaced by permanent end financing in the form of a traditional mortgage. This longer-term home loan uses the completed house as collateral.

Benefits of Using Land as Collateral

Using vacant land as collateral provides several advantages for financing new construction:

• Access capital to start building – The equity in your land allows you to tap funds to start construction right away.

• Avoid paying both mortgage and construction loan – Using your land as collateral lets you wrap everything into one set of financing.

• Lower down payment requirements – Lenders may require less money down compared to a standard construction loan since your land provides collateral.

• Only one closing – Land-secured construction loans generally have a single closing versus multiple closings on other construction loans.

For these reasons, land-collateralized construction financing provides a streamlined way to fund your custom build.

How Do Construction Loans Work?

Construction loans have a few unique mechanics compared to regular mortgages:

• Loan term – Usually 6-12 months to finish house construction. Extensions are sometimes allowed for an additional fee.

• Interest-only payments – You only pay interest on the funds disbursed to the builder, keeping payments lower.

• Draw schedule – The lender distributes money in installments as specific project milestones are met.

• One-time or two-time close – Loan can be structured as a one-time close with a single conversion to a mortgage, or a two-time close requiring a separate permanent financing closing.

• Variable or fixed rate – Interest rate can be variable during construction then fixed for the mortgage, or locked for the full term.

• Lower loan-to-value ratio – Maximum percentage of the home’s value that lenders will fund is typically lower than on standard mortgages.

It’s critical to ask lenders detailed questions about their construction loan products to understand exactly how they work. Policies vary significantly from one lender to another.

What are Eligibility Requirements?

To qualify to use land as collateral for a construction loan, requirements typically involve:

• Clear land title – You must have a clear title to the property without any claims against ownership.

• Zoning and permits – The land must be zoned for your intended type of construction and you need proper permits.

• Equity and value – You usually need at least 20-30% equity in the land value to secure financing.

• Credit and income – Most lenders require a minimum 660 credit score and stable income to repay the loan.

• Approved plans – Detailed construction plans must be submitted and approved before funding begins.

• Budget – A complete project budget detailing all costs is usually mandatory for loan approval.

• Construction contract – Fully executed deal with a licensed general contractor is often required.

Meeting these requirements demonstrates you are ready to take on the financial obligation of building a home. Check with individual lenders for their specific policies.

How is Loan Amount Determined?

When using land as collateral, the amount you can borrow is based on:

• Appraised land value – Recent appraisal showing fair market value. More equity means more borrowing power.

• Construction costs – Documented expenses for materials, labor, fees shown in complete budget.

• Loan-to-value limits – Lender’s maximum percentage of total costs they will finance (often 75-85% of total).

• Borrower qualifications – Factors like income, assets, credit score determine the size of loan approved.

To optimize your loan amount, look for lenders that finance up to 80-90% total costs and find ways to boost your land’s appraised value. Coming up with more cash for a larger down payment can also increase the approved borrowing limit.

What is the Application Process?

When using land as collateral for a construction loan, you’ll go through these key steps:

• Choose lender – Find lenders experienced with construction loans secured by land. Shop rates.

• Check eligibility – Confirm you meet credit, income, equity requirements before applying.

• Submit application – Complete paperwork detailing costs, timeline, contractor, permits, plans, etc.

• Get land appraised – Lender will evaluate current fair market value based on recent appraisal.

• Verify ownership – Prove clear title to the property through title search and title insurance.

• Close on loan – Initial loan documents are signed and funds are secured.

• Finalize contract – Fully execute deal with general contractor outlining scope of work.

• Break ground – After closing and securing permits, construction can begin!

Takeaway Tips

If looking to use land as collateral for construction financing, keep these tips in mind:

• Shop multiple lenders and compare costs, rates, terms, requirements.

• Understand exactly when and how draws will be released to avoid payment issues.

• Build in contingencies for unexpected delays and get loan term extensions if needed.

• Get everything in order like plans, permits, contractor before applying for fastest approval.

• Monitor construction progress closely and proactively communicate with lender to prevent problems.

Using your vacant land as collateral for a construction loan opens up an efficient financing option to build a custom home. Just make sure you fully understand the loan details and are prepared for the construction process.