Loans for Land and Construction: A Complete Guide

Purchasing land and constructing a home from the ground up can be an exciting endeavor. However, it also requires careful planning and financing. Loans specifically for land and construction projects can provide the funding needed to turn your dream home into a reality. In this comprehensive guide, we’ll explore everything you need to know about loans for land and construction.

Land and construction loans are specialty loans designed to finance both the purchase of a property lot and the construction of a new home on that lot. These loans are also sometimes called lot loans or construction-only loans. They provide funds for buying land and then building a residential property on it.

Land loans finance just the purchase of the lot itself Construction loans only finance the building of the home Land and construction loans bundle these two needs into one convenient loan product.

These loans are typically secured by the property, meaning if the borrower defaults the lender can seize the land and any partially constructed home on it Lenders view these type of loans as higher risk than loans for existing homes. Therefore, qualification requirements tend to be stricter.

Benefits of Land and Construction Loans

There are several advantages to land and construction loans compared to other financing options:

• One loan for land purchase and construction – The entire project is financed with one loan and one closing. There’s no need to shop for separate land and construction loans.

• Potentially lower costs – Bundling into one loan saves money on multiple application fees and closing costs. Interest rates may also be lower with a combined loan.

• Fixed interest rate – These loans often allow borrowers to lock in a fixed rate. This provides protection from rate hikes during the construction period.

• Access to incentives – In some cases, lenders offer incentives for construction loans that make them more affordable. For example, waiving application fees or offering discounted interest rates.

• Ability to customize – Borrowers can build the home layout and features they want, rather than accepting an existing home’s design.

• Land equity – Any equity in the land can be used towards down payment and fees for building costs.

For those wanting to build their own dream home, a land and construction loan can be the most efficient way to finance it with one straightforward loan process.

How Land Loans Work

Before diving into the combined land and construction loans, it helps to understand how the component loans work independently:

Land Loans

Also called lot loans, these finance the purchase of vacant land that does not yet have a property built on it. The land itself serves as collateral for the loan.

The borrower makes payments on the land loan until they are ready to construct a home and either sell the property or convert the loan to a regular mortgage. These loans typically have higher interest rates and require large down payments of 20% or more.

Land loans require strong credit, as well as a clearly defined plan for how the property will be developed. Overall, they are riskier for lenders than loans on existing houses, so qualification standards are stricter.

Construction Loans

With a construction loan, financing is provided solely to build a home on a lot that the borrower already owns. Lenders disburse funds in stages based on completion of certain phases of construction.

A key benefit of construction loans is that borrowers only pay interest on the money disbursed so far, rather than on the full approved amount. These loans also typically have variable interest rates, allowing lower rates during construction.

Construction loans are short-term loans that are paid off as soon as the home is completed, usually by obtaining a standard mortgage. At permanent financing, the construction loan is either paid off or converted into a traditional mortgage through refinancing.

How Land and Construction Loans Work

A land and construction loan combines features of both loan types:

• The loan finances purchase of vacant land or a lot
• It also finances construction of a new home on that lot
• There is a conversion process to transition to permanent financing once construction is complete

Here are some key steps in the land and construction loan process:

• Borrower finds and selects an ideal lot for their custom home
• Contractor or builder is secured to construct the home
• Loan application and approval determines loan amount to cover land purchase and construction
• At closing, loan funds are disbursed to purchase the lot
• As phases of construction are completed, additional funds are disbursed to the builder
• Interest payments are made, usually only on disbursed amounts not total loan
• Once home is completed and occupancy permit obtained, the construction loan converts to permanent financing

The conversion is handled either by paying off the land and construction loan with funds from a new mortgage, or refinancing the construction loan into a traditional mortgage.

Tips for Getting Approved

Because lenders consider land and construction loans riskier than financing existing homes, borrowers need to take steps to improve their chances of getting approved:

• Have a high credit score – 720 or higher is ideal. This saves on interest and shows responsibility.

• Large down payment – Plan for 20-25% down of total project costs. This demonstrates ability to pay and commitment.

• Secure building plans – Formal blueprints and building specifications can give more credibility.

• Select reputable builder – Their track record can provide confidence in successful construction.

• Document contingencies – Have realistic plans and accounts set up to handle unforeseen costs.

• Show low debt-to-income ratio – Keep recurring debts like car loans or credit cards low compared to income.

Taking these proactive measures, even before formally applying, can go a long way towards getting approved.

Land and Construction Loan Rates and Terms

Land and construction loans tend to have different rates and terms than conventional mortgages:

Interest rates – Interest on land loans is typically higher than for existing homes, often 0.5 to 1% higher. Rates for the construction portion may be variable for flexibility.

Down payment requirements – 20-25% down is often required, split between the land purchase and building costs.

Loan term – The construction portion usually has terms of 12 months or less. Permanent financing after conversion often has longer terms of 15 or 30 years.

Loan amounts – Since no existing collateral, loan amounts are tied to land value and construction estimates only. Loan-to-Value limits apply.

Occupancy – Most lenders require the borrower to occupy the home as a primary residence after construction.

Prepayment penalties – These loans sometimes have penalties for early payoff, especially during construction.

Be sure to discuss rates, timelines, contingencies and all costs with any potential lenders when shopping for land and construction loans.

Steps for Getting a Land and Construction Loan

If you’re considering applying for a land and construction loan, follow these steps:

1. Find a lender – Research local banks, credit unions, and mortgage companies that offer these specialty loans.

2. Select a lot – Determine where you want to build and find land for sale in that location.

3. Develop construction plans – Create detailed building plans, blueprints, budgets, and a construction timeline.

4. Hire a builder – Find an experienced general contractor or home builder in your area.

5. Apply for loan pre-approval – Submit loan application, credit info, budgets, and other required documents.

6. Shop for best rate – Compare multiple lender rate quotes and terms to find the best deal.

7. Close on loan – Finalize loan, sign documents, finalize land purchase, and disburse initial payment to builder.

8. Oversee construction – Work closely with your builder and lender throughout the building phase and draw loan disbursements.

9. Convert to permanent financing – When home is complete, convert to a traditional mortgage or other long-term home loan.

Following these steps can help your construction project go as smoothly as possible.

Alternatives to Land and Construction Loans

Although they are tailor-made for building a custom home, land and construction loans are not the only financing option. Some alternatives to consider include:

Construction-Only Loans – Separate loan for just building costs. Require you to finance the land purchase separately.

Single-Close Construction Loans – One loan that converts to permanent financing but doesn’t include land purchase.

Consumer Loans – Personal loans or home equity loans can provide funds but at higher rates and payments.

Owner Financing – Having the property seller finance your purchase directly if you initially can’t qualify for a loan.

Custom Homebuilder Financing – Some builders, especially larger companies, offer in-house financing options.

Private Investors – Finding individuals willing to fund all or part of your land purchase and construction costs for a share of ownership or repayment with interest.

Shop around to find the very best rate and terms for your particular situation.

Finding the Right Lender

The lender you choose can make a big difference in getting approved and having the smoothest financing process possible. Here are some tips