construction loan with land purchase

Building Your Dream Home With A Construction Loan That Covers Land Purchase

Purchasing land and building a custom home from the ground up is an exciting prospect for many homebuyers. Being able to design and construct your perfect living space on a property you own can be incredibly rewarding. However, financing the purchase of vacant land and the construction of a new house on that land requires a unique type of loan: a construction loan.

What Is A Construction Loan?

A construction loan is a short-term financing option intended to cover the costs of building a new home. This includes purchasing the lot or land, paying for labor and materials, securing necessary permits, hiring contractors, and covering other expenses tied to the construction project.

Unlike a traditional mortgage, which is a long-term loan to buy an existing house, a construction loan provides funding during the building phase. Once the home is completed, the construction loan converts into a permanent mortgage so you can pay off your finished home over 15 or 30 years.

Construction loans allow buyers to spread out the financing rather than paying for everything upfront in cash. Since building a home is a lengthy and expensive undertaking, these specialized loans make the construction process affordable.

Can A Construction Loan Cover Land Purchase?

Yes, construction loans can cover both the purchase of the land and the costs of building on that land.

When you apply for a construction loan, the lender will provide one loan amount that includes the price of the vacant lot along with an estimate for construction costs. This lump sum will be dispersed in stages as certain milestones are reached during the building phase.

Including the land purchase in the construction loan simplifies the financing process. You don’t have to take out a separate mortgage or lot loan for the land. The construction loan bundles everything together into one tidy package.

Combining the land and build financing also allows you to convert the entire amount into a traditional mortgage after the home is finished. You won’t be left with an outstanding loan just for the land that has to be paid off later.

How Do Construction Loans Work?

Construction loans provide funding in planned installments, called draws, rather than in one lump sum. Here is an overview of the construction loan process from start to finish:

• Get prequalified: Work with a lender to determine the loan amount you qualify for based on your income, assets, credit score and other financial factors. This will influence your construction budget.

• Find land: Search for a suitable lot or acreage for your home build. If you already own land, the value will count toward your total loan amount.

• Apply for loan: Submit your official loan application and documentation so the lender can underwrite and approve your construction financing.

• Secure permits: Obtain all required building permits before kicking off construction. These permit fees can often be included in your loan.

• Close on loan: After approval, you’ll officially close on the construction loan and should receive the first disbursement to purchase the land if needed.

• Begin construction: With permits approved and land secured, start the building process per the approved plans.

• Draw loan funds: As certain stages of construction are completed, the lender will release additional funds from your loan to pay the contractors.

• Finish construction: Once your home is move-in ready, the final loan funds will be dispersed to cover the last construction costs.

• Convert to mortgage: Work with your lender to switch the construction loan into a fixed-rate mortgage you can pay off over 15-30 years through regular principal and interest payments.

As you can see, at each major step of the construction timeline, funds are drawn from the loan to pay for that portion of the project. You only get as much money as you currently need, which helps eliminate waste.

Pros And Cons Of Construction Loans

Combining your land purchase and home building into one construction loan makes financing a custom home build easier. However, these loans come with some advantages and disadvantages to weigh.

Pros:

• One loan for everything: You don’t need separate loans for the land and construction.

• Predictable draws: Payments are dispersed at set intervals, not all at once.

• Usually lower rates: Construction loans may offer better rates than other financing options.

• Only one closing: You close once on the construction loan and mortgage.

• Potentially easier to qualify: Some construction loans have lower credit score requirements than mortgages.

Cons:

• More complex process: Construction loans require more effort and oversight than buying an existing home.

• Short term: These loans must be paid off or converted to a mortgage once the home is finished.

• Strict draw schedule: You only get funds at certain times during the build process.

• More fees: Construction loans come with upfront fees plus closing costs when you convert to a mortgage.

• Rate fluctuations: Your rate isn’t locked until you convert to permanent financing.

As you weigh the pros and cons, think about whether you are prepared for the extra responsibilities of acting as your own general contractor. Also consider if you can handle the construction loan converting to a mortgage in as little as six months.

Construction Loan Rates And Fees

Construction loan rates and terms can vary significantly between lenders. Here are some average costs associated with construction loans:

• Interest rates: Expect construction loan rates around 0.25% – 2% higher than mortgage rates. Average construction loan rates currently range from 5% to 8%.

• Origination fee: Upfront fee of around 1% – 2% of the loan amount.

• Draw fees: Each time you receive a construction draw, a fee applies, often $50 – $150 per draw.

• Inspection fees: Charged each time the lender sends someone to inspect the progress before approving the next draw. Typically $100 – $300.

• Credit report fee: Around $50 per applicant.

• Conversion fee: Fee to switch the construction loan to a mortgage, ranging from 0.5% – 1% of the balance.

• Closing costs: When you convert to a mortgage, expect to pay title insurance, appraisal fees, and other closing costs.

Be sure to get a full breakdown of all fees from lenders when shopping construction loans. The costs can add up quickly.

Getting Approved For A Construction Loan

Since construction loans are more complex than traditional mortgages, the approval process is also more rigorous. Here are some key requirements to qualify for a construction loan:

• Down payment: Expect a 10% – 20% down payment, more than a typical mortgage. Some lenders may accept 5% down.

• Credit score: Most lenders look for a minimum score around 650 – 700. The higher your score, the better.

• Debt-to-income ratio: Your total monthly debt payments, including the construction loan, should not exceed 43% of your gross monthly income.

• Loan-to-value ratio: The loan amount will be based on the “as completed” appraised value of the home. The max LTV is typically 80% – 90%.

• Reserves: You may need 12+ months of mortgage payments in reserves after closing. Reserves provide a financial cushion in case the project goes over budget.

• Plans and specs: Lenders will review your detailed construction plans and specifications before approving the loan. Blueprints may be required.

Also note that most lenders require a general contractor to oversee the building process. You usually cannot act as owner-builder, which is riskier. Shop around with builders to get quotes before applying for a construction loan.

The bottom line is construction loans have more qualification hurdles than mortgages. But for borrowers who can leap those hurdles, these loans provide an affordable path to building a custom home.

Alternative Construction Loan Options

If you have a hard time getting approved for a traditional construction loan, alternatives do exist. Here are a few options to discuss with lenders:

Renovation Loans: Fund additions and major remodels for an existing home instead of new construction. Often easier to qualify for than construction loans.

Land Loans: Separate short-term loan to purchase land only. You get a construction loan later to build the house.

Manual Underwriting: Lenders review your full financial picture manually rather than relying only on credit score requirements.

Low-Down Payment Loans: Programs like FHA, VA and USDA loans offer 3.5% – 0% down options for qualifying borrowers.

Portfolio Loans: Held by local banks rather than sold on the secondary market. Tend to have more flexible approval guidelines.

Non-QM Loans: Non-qualified mortgages fall outside Fannie Mae and Freddie Mac lending standards but may offer expanded options for borrowers.

Investigating these alternative mortgage products could provide viable construction financing if your circumstances don’t align with a cookie-cutter construction loan. A knowledgeable loan officer can help you identify the optimal loan program for your needs.

The Bottom Line

Building a custom home is an ambitious undertaking. Construction loans make achieving this dream possible by providing financing for every step from purchasing land to the final finishing touches.

If you think a construction loan is right for you, the next step is connecting with lenders. Be sure to get multiple loan estimates so you can compare interest rates, fees and qualification requirements.

With diligent research upfront and thoughtful preparation, you’ll be well