Buying land and building a custom home is an exciting prospect for many homeowners. The ability to design and build your perfect home from the ground up is appealing. However, financing the purchase of land and construction of a new home requires specialty lending that many borrowers may not be familiar with.
In this comprehensive guide we’ll cover everything you need to know about loans to build a house and buy land.
An Overview of Construction Loans
A construction loan is a short-term loan used to finance the building of a new home. This type of financing covers the costs to:
- Purchase the land
- Pay for labor and materials
- Cover permit fees and other construction costs
With a construction loan, funds are issued in stages as construction milestones are met. This ensures the work is completed as expected before the lender releases additional funds.
Once construction is finished, the construction loan converts into a traditional mortgage. You’ll use the permanent mortgage to pay off the builder and maintain ownership of the completed home.
Construction loans make building a custom home affordable by breaking costs into multiple draws over 6-12 months. This can be easier to manage than paying for everything upfront in cash.
Below are some key things to know about construction loans:
- Interest rates are variable – The interest rate fluctuates over the loan term.
- Require a downpayment – You’ll need around 20% down to qualify.
- Short-term financing – Repaid once home construction is complete.
- Interest-only payments – You only pay interest until the home is finished.
Now let’s explore popular construction loan types in more detail.
Types of Construction Loans
There are a few varieties of construction financing to be aware of:
Single-Close Construction Loans
Also called one-time close or all-in-one construction loans, single-close loans provide financing for the land purchase, construction, and permanent mortgage wrapped into one loan.
Single-close construction loans make the process simpler by requiring only one application and closing. However, these loans can be challenging to find through lenders.
Two-Close Construction Loans
A more common option is the two-close construction loan. With this type, you’ll complete two separate loan processes:
- Short-term construction loan – For financing the building of the home.
- Permanent mortgage – For repaying the construction loan once the home is complete.
The two-close option provides more flexibility. But it also requires two separate loan applications, approvals, and closings.
Construction-to-Permanent Loans
Construction-to-permanent loans combine the construction loan and permanent mortgage into one loan upfront. However, you’ll still make two separate closings – one before construction starts and another for the permanent mortgage upon completion.
The single-close construction loan provides the simplicity of having both loans arranged early on. At the same time, the two-closing structure allows flexibility to shop for the best permanent mortgage after construction.
Construction Loan Requirements
As specialty financing, construction loans come with strict requirements for borrowers. Here are some common criteria:
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Downpayment – Expect a 10-20% downpayment requirement. Some lenders may allow as low as 5% down.
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Credit score – Most lenders require a minimum credit score of 620-680. The higher your score, the better.
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Debt-to-income ratio – Your total monthly debt divided by gross monthly income should be below 43%.
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Loan-to-value ratio – The loan amount as a percentage of the completed home’s value needs to be 80% or lower.
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Contingency fund – You may need 10-20% of the project costs set aside for unexpected overages.
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Construction experience – Prior building experience may be required to show you can manage the project.
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Plans and specifications – Detailed plans are usually needed before the lender will approve funding.
As you can see, construction loans have higher barriers to qualification compared to conventional mortgages. Work on improving your credit and finances to boost your chances of approval.
How Construction Loans Work
Now let’s walk through the construction loan process from start to finish:
1. Find Land to Purchase
The first step is locating a suitable lot or land to build on. Factors like size, terrain, access to utilities, and zoning requirements should be considered. REALTORS® can help you identify and purchase appropriate land for your planned home.
2. Select a Contractor
Vet and choose a qualified general contractor to oversee your project. Ask to see examples of previous work and check references thoroughly. The right contractor is key to ensuring your build goes smoothly.
3. Apply for a Construction Loan
Once you have land and a contractor lined up, you can apply for a construction loan. Your lender will assess your finances and plans to approve or deny funding.
4. Close on the Loan and Purchase the Land
If approved, you’ll close on the construction loan and can move forward with buying the land. Now the fun part begins!
5. Break Ground on Construction
With financing and land acquisition complete, your contractor can break ground. Construction milestones like pouring the foundation and framing will commence.
6. Receive Disbursements as Work Progresses
As phases of construction are completed per the specs, the lender will release additional loan disbursements to the contractor to fund the next steps.
7. Complete Construction
Within 6-12 months, your new home will be finished and ready to move into!
8. Convert to a Permanent Mortgage
Finally, you’ll convert the construction loan into a traditional mortgage. You’ll make monthly payments on the fixed-rate loan to pay off your new home over 15-30 years.
And that’s how construction loans allow you to buy land and build your dream home!
Construction Loan Interest Rates
A unique aspect of construction loans is that they often come with variable interest rates. This means the rate you pay fluctuates over the course of the construction as an index the lender uses changes.
It’s impossible to know exactly what a construction loan will cost in total interest when rates adjust monthly. An estimate of the total interest costs can be made by taking the current rate and projecting it over the loan term.
On a positive note, construction loans often start with very low teaser rates. As low as 1-3% at the beginning of construction. But expect the rate to climb higher as the project progresses.
Once construction is complete and the loan converts to a traditional mortgage, you’ll receive a fixed interest rate. This provides consistent, stable payments over the remainder of repayment on your home.
Construction Loan Fees
Beyond the interest costs, note that construction loans come with sizable fees. Here are some common fees you’ll pay:
- Origination fee – 1-5% of the loan amount to arrange financing.
- Application fee – $100+ to apply for the construction loan.
- Inspection fees – Paid each time the lender inspects completed work prior to releasing funds. Expect multiple inspections.
- Closing costs – Typical closing fees like appraisal, processing, underwriting, and attorney costs apply.
- Conversion fee – 1%+ of the loan amount to convert to a permanent mortgage.
Factor all loan fees into your total construction budget. Unexpected fees can derail your project if you’re not prepared.
Alternatives to Construction Loans
For some borrowers, construction financing may not be accessible or affordable. Here are a few alternatives to consider:
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USDA construction loans – For building in rural areas, USDA programs offer affordable construction financing options.
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VA construction loans – Veterans have access to VA construction loans with favorable terms.
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FHA construction loans – FHA construction financing is available for those who meet credit requirements.
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Renovation loans – Not exactly new construction, but renovation loans can finance fixes and upgrades for existing homes.
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Personal loans – A cheaper short-term financing option is borrowing a personal loan, then paying cash for construction.
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HELOC – Similarly, a home equity line of credit provides access to cash that could fund a construction project.
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Owner financing – Asking the land seller to finance the purchase directly can be less expensive.
Evaluate all your options to find the most suitable construction financing for your situation.
5 Tips for Getting Approved
Approval for a construction loan is challenging. Implement these 5 tips to boost your chances of getting approved:
❏ Improve your credit – Increase your score before applying for the best interest rates. Pay down balances and correct errors on credit reports.
❏ Lower your debt – Reduce monthly obligations like credit cards, auto, and student loans. This will improve your debt-to-income ratio.
❏ Make a larger downpayment – Put down 20% or more if possible. This lowers the amount you need to finance.
❏ Shop multiple lenders – Apply with several lenders an
Can you buy land with a USDA construction loan?
A USDA construction loan allows you to purchase both the land and the home. But some restrictions apply. For example, the land must be in a USDA-approved location. These areas must be “rural in character,” though many small towns and suburbs qualify.
“Also, this is not a loan that you can use to purchase land now and build on it at a later time. Once you close on the loan, you are expected to start building when given the green light, which is usually quickly,” says Richie Duncan with Nationwide Home Loans Group.
If you want to purchase land first while you are shopping for builders, this is allowed. You can take out a loan elsewhere to buy the land, and then a USDA construction loan lender can include the payoff of that land balance in your new loan.
“If you pay cash or already own the land free and clear, you cannot get cash back or be paid back. That would involve a cash-out loan, which is not allowed in any version of a USDA loan,” cautions Mushlin with BuildBuyRefi.com.
Note that it’s not necessarily easier to get a USDA construction loan if you already own the land. Although it might be easier to get another type of new construction loan.
“Having your land paid off or owned outright will reduce your loan-to-value ratio (LTV), which means you won’t need 100% financing,” Duncan continues. “This increases your possible equity position and will lower your payment further than a borrower purchasing new land or paying full price for the land.”
USDA construction loan requirements
Government-backed mortgage programs often come with numerous requirements that both the property and the borrower must meet. USDA construction loans are no different. In fact, because of the complexity of this land loan, qualifying can be challenging for many potential borrowers.
To be eligible for a USDA construction loan, you must meet a number of guidelines, including certain credit score and household income requirements.
- Most lenders require a 640 minimum credit score
- Your debt-to-income ratio (DTI) should not surpass 41%. This includes keeping your monthly housing expenditure below 29% of your monthly pretax income
- You must not have experienced bankruptcy in the last two years
- You cannot exceed USDA income limits based on your area’s median income (AMI) and the size of your family. The USDA Rural Development program is intended to help moderate- and low-income families purchase and build homes
Your lender will also look for 12 to 24 months of clean, unblemished credit history, no gaps in your household income, no mortgage forbearance, and no late or missing rent payments.
“Basically, you want to have the cleanest credit, income, and debt-to-income ratio possible to get this loan,” suggests Brandon Mushlin with BuildBuyRefi.com.
In addition to the borrower requirements for a USDA construction loan, the property you intend to buy must also comply with a number of other guidelines before the USDA will approve your loan application.
- The property must be located in an eligible rural area
- The property must be your primary residence
- You must use a USDA-approved contractor for the construction
- You must receive a new construction warranty from the builder
- Any remaining funds after construction ends must be applied directly toward your principal loan balance
In addition, the types of homes eligible to be built are limited to single-family homes, manufactured homes, and eligible condominiums.
“Second or vacation homes, homes intended to be used for short-term or long-term rentals, accessory dwelling units, self-built homes, commercial buildings, and mixed-use construction are not eligible,” adds Richie Duncan, senior loan officer with Nationwide Home Loans Group.
For a USDA new construction loan, the project’s contractors must meet certain qualifications. These USDA contractor requirements include:
- Approval from your lender
- A minimum of two years’ experience in constructing single-family homes
- Full licensing for the construction work
- A solid credit history and a clean background check
- At least $500,000 in liability insurance coverage
Use A Construction Loan To Build A House?
FAQ
How hard is it to borrow money to buy land?
Is it harder to get a loan to build a house?
Is it better to buy land first and then build?
Which loan is best for buying land?
How do I get a Home Builder loan?
You can obtain a land or construction loan from a local credit union or community bank. Remember these loans get your house built, but in most cases you will also need to obtain a mortgage. If you are not ready to begin construction right away, a land loan is probably your best option.
Should you buy land if you have a construction loan?
Buying the land to build your house is likely to be one of the most expensive items in the overall construction cost. However, securing a construction loan is already quite complex, and, if you can, it makes sense to buy land separately from your construction loan. The best way to do that is to buy the land up front.
Can I finance a land purchase & construction for my home?
Yes, if you want to finance a land purchase and construction for your home, you can apply for a construction loan. This is a short-term loan covering the land, labor, materials and permits. Once your home is built, you’ll convert the loan into a mortgage to pay for the completed home.
Can a land loan be used to build a house?
If you want to design from the ground up, a land loan may be the best choice for you. You can get started by exploring open lots in your area to find the perfect spot to build. Rocket Mortgage doesn’t offer land loans, but we may be able to help you refinance an existing land or construction loan to a traditional mortgage on your newly built house.
What type of loan should I take out when buying land?
The type of loan you take out will depend on where you’re buying land and how you intend to use the land. A land loan is sometimes confused with a construction loan, which is another type of loan often used by people looking to build a house.
Do you need a construction loan to build a house?
Building a house from scratch can be a great opportunity to get the home you’ve always wanted. But construction costs can add up quickly and timelines can be unpredictable. Luckily, a variety of construction loans provide the upfront cash needed to pay for the land, materials and labor to build a new house. What Is a Construction Loan?