Everything You Need To Know About Loans For Land And Construction

Purchasing land and building a custom home from the ground up is an exciting prospect for many homeowners. However, it also comes with a unique set of financing challenges. Traditional mortgages require an existing structure as collateral, so you’ll need an alternative source of financing to cover both the land purchase and construction costs. That’s where construction loans come in.

In this comprehensive guide, we’ll walk through everything you need to know about loans for land and construction. We’ll cover the pros and cons, costs, qualification requirements, and step-by-step process. Whether you’re just starting to explore this option or are ready to move forward, the information below will ensure you make the most informed decision.

What Is A Construction Loan?

A construction loan, also known as a build loan, is a short-term financing option meant to cover the costs of building a new home from the ground up It is very different from a traditional mortgage in both purpose and structure

While a mortgage is meant for purchasing an existing property a construction loan provides the funding needed to

• Purchase the land
• Pay contractors and subcontractors
• Cover materials and labor
• Pay permitting fees and other construction-related costs

Instead of making one large lump sum payment like with a mortgage, the loan funds are issued in phases as certain milestones are met during the building process.

An independent appraiser will determine the home’s future market value once construction is complete. The construction loan amount will be based on that appraisal, and will cover up to 90% of total building costs.

Once construction is finished, buyers will either sell the home or convert the construction loan into a traditional mortgage. This is known as the loan “conversion”.

The Pros And Cons Of Construction Loans

Construction loans offer several advantages over other financing options, but also come with downsides to consider:

Pros

• Customization: You can build the home exactly to your specifications.

• Potentially lower cost: In some markets it may be cheaper to build than buy an equivalent existing home.

• Brand new condition: No need to renovate or make repairs as you would with an older property.

• Equity building: Your equity position starts increasing as soon as construction begins.

Cons

• Higher costs: Interest rates are typically 0.5 to 1% higher than rates for traditional mortgages.

• More complex approval: Qualifying standards are more stringent compared to a standard mortgage.

• Strict timeline: The home must be completed before the maturity date, usually within 6-12 months.

• Variable rates: Most construction loans have adjustable rates that fluctuate during the building phase.

As you can see, construction loans require some trade-offs. Make sure the benefits of building new outweigh the drawbacks for your situation.

What Are The Costs Associated With A Construction Loan?

While every lender is different, you can expect to pay the following fees when taking out a construction loan:

• Origination fee: Upfront fee equal to 1-2% of the loan amount.

• Application fee: $50-100 to cover processing costs.

• Inspection fees: Paid each time the lender inspects the property, around $200 per visit.

• Appraisal fee: $300-500 for the appraiser to estimate the future property value.

• Credit report fee: $25-50 per person to cover credit check costs.

• Conversion fee: Around $200 when converting to a mortgage after construction.

• Interest payments: Due monthly on the funds issued so far.

• Property taxes and insurance: Must be paid for the duration of the building phase.

As you budget for the project, be sure to account for these additional closing costs and recurring payments.

What Are The Qualification Requirements?

Construction loans have higher qualification standards than standard mortgages, for a few reasons:

• The lender takes on more risk, since there is no existing home as collateral.

• The adjustable rate means buyers need to be prepared for higher payments.

• Any delays in construction pose a hazard.

While criteria varies by lender, here are some typical requirements:

• Down payment: 20-25% down required in most cases.

• Credit score: Minimum 620, but many lenders require 640+ scores.

• Debt-to-income ratio: Must be below 43% in most cases.

• Cash reserves: Expect to show 6-12 months of mortgage payments in reserve.

Meeting these standards demonstrates you are financially stable enough to take on the risks and responsibilities of new construction. Be realistic about whether you qualify before moving forward.

Step-By-Step Construction Loan Process

If you’ve decided that a construction loan is your best approach for financing land and building costs, here is an overview of what to expect.

1. Find the Land

First you’ll need to identify and purchase a suitable property to build on. Be sure to consider factors like:

• Budget
• Location
• Lot size
• Zoning restrictions

A real estate agent can help you find land listings for sale. Make sure your purchase agreement is contingent on obtaining financing.

2. Select a Contractor

Finding an experienced general contractor is crucial, since they will oversee the entire construction process. Thoroughly vet any contractors you are considering. Get copies of their certification, licensing, and proof of insurance.

Check reviews and references to ensure past clients have been satisfied with their work. Make sure you get a detailed written contract covering project scope, timeline, contingencies, and payment schedule.

3. Choose a Construction Lender

Shop around with several lenders to compare loan options and interest rates. Look for a lender that is experienced with construction loans and familiar with builders in your area. This will help ensure a smoother approval and building process.

4. Apply for the Loan

Once you have estimates from your contractor, you can complete the loan application. Be prepared to submit details on:

• Income and assets
• Credit history
• Building plans and specs
• Property information
• Construction budget and timeline

Also provide any large down payment funds you have available upfront.

5. Close on the Loan

If approved, you will close on the construction loan and can begin preparing the land for building. Only pay the contractor from your loan funds, never from your own accounts. An independent inspector will visit periodically to ensure work meets specifications before releasing additional payments.

6. Complete Construction

Within the allotted timeline, your contractor will finish building the home according to the approved plans. The inspector will make a final visit to guarantee everything is complete and satisfactory.

7. Convert to Permanent Mortgage

Once the home is finished, you can convert the construction loan into a traditional 30-year fixed-rate mortgage. This provides long term financing you can use to pay off the interim construction loan.

The conversion process is simple. The lender will order a new appraisal to determine the home’s market value. You will go through mortgage underwriting using the home itself as collateral now.

Finding The Best Construction Loan Lender

As you can see, the lender you choose can make or break the construction loan process. Here are some tips for finding the best lender:

• Ask friends, your realtor, and general contractor for recommendations.

• Opt for an established institution that specializes in construction lending.

• Compare interest rates and loan fees across multiple lender options.

• Make sure they have a local presence and are familiar with builders in your area.

• Ask about their inspection and payment disbursement processes.

• See if they offer a construction loan conversion program for long term financing.

Choosing the right lender provides important peace of mind during an already stressful building project. Be picky when researching your options to find the best fit.

Alternatives To Consider

While construction loans are the go-to for financing new construction, they aren’t your only option. Depending on your unique situation, consider these alternatives:

Land Loan – Finances the land purchase separately, then apply for a construction loan later.

Portfolio Loan – Some local banks may offer combined land and construction financing.

Homestyle Renovation Mortgage – Can fund smaller construction projects if adding onto an existing home.

FHA 203(k) Loan – Combines home purchase and renovation costs into one government-backed mortgage.

VA Construction Loan – VA-guaranteed loan that may have lower requirements than conventional alternatives.

USDA Construction Loan – For building in rural areas, offers subsidized rates to qualified applicants.

Owner Builder Construction – If you have the skills, you may act as builder to save on labor costs.

Talk to a loan officer to discuss if any of these options are a good fit for your construction plans and budget.

Is A Construction Loan Right For You?

While rewarding in the long run, embarking on new home construction is not a decision to take lightly. Make sure you consider