Buying land and building a new home can be an exciting experience, and if you plan to get financing you need to understand your options related to lot loans, land loans and construction loans.
What kind of loan is right for you? Even though it may seem obvious, this question does not always have a clear answer and the subject often is misunderstood by potential borrowers. It’s important to understand that these loans have unique characteristics and the lending options that are available for you will depend on factors like your personal situation, the type of property you are buying, your level of preparation and your timing for building a home. This article will provide an overview of (a) Lot and Land Loans, and (b) Home Construction Loans, to help you consider what fits your needs. A related article in this series goes into more detail about the terms for lot and land loans and another describes the terms for construction loans.
These Loans Are Different
Most homeowners are familiar with the typical mortgage loan used to finance the purchase of an existing, already-built home (referred to by some as a “purchase money” mortgage or loan). Purchase money loans are the standard of the residential lending industry, and entire financial markets, mortgage products and automated systems have been created to make these loans efficient and easy for banks to underwrite and process.
But conventional purchase money mortgages are different from lot, land and construction loans – both in how they are structured and how lenders underwrite, process and account for them – and understanding these differences is perhaps the most important takeaway that potential borrowers need to grasp before seeking a loan for buying land or building a home. Read about why banks treat these loans differently.
A fundamental basis for this difference is that, before providing financing for your purchase of vacant land or a construction loan to build your home, a bank needs to understand your plans for the property. The purpose and timing for a purchase money loan is known and obvious – you’re buying an existing home of a certain value at your closing – but there is more uncertainty about the facts, valuation and what the future holds when working with a vacant land loan or a construction loan. Details about the property and your overall story will influence the perceived risk to the lender and help the lender decide whether it will approve your loan. For this reason, land loans and construction loans are often referred to as “story loans.”
Loans to Buy Vacant Land or a Lot
Ready to buy a homesite, but not quite ready to build your new home? Many buyers are looking for – or already have found – the ideal lot or vacant property for building their future home, but need to wait before they start construction. Life and financial situations (job, children, selling an existing home) can play a big part in whether someone is ready to start building a home from the ground up, and for some the time is not right to take on the task. If that is your situation, you likely will want to consider some form of “lot loan” or “land loan” to make your vacant property purchase first. And later, when you’re actually ready to build a home on your lot, you can consider your construction loan options.
A lot or land loan allows you to secure your ideal homesite so you can continue to get ready to build your home. Borrowers can use the time after they close to plan their new home and its design. If they haven’t partnered with anyone yet, then some will use this time period to find their ideal home builder. And maybe this time allows you to settle into a new job or your children to graduate from college.
From a borrower’s perspective, lot and land loans are both harder to find and have less favorable terms than a conventional purchase money mortgage for a home. Although lot and land loans are structured and documented similar to purchase money home loans, be prepared to see shorter-term loans, higher down payments, higher interest rates and additional borrower commitments and underwriting. We have discussed both lot and land loans together here, but some lenders have different loan terms and programs that distinguish between finished lots (ready-to-build, with utilities and roads) and undeveloped vacant land. Read more details about how lot and land loans work.
New Home Construction Loans
Ready to have your new home built right away? If you have (or soon will have) all your ducks in a row – you’ve found your lot, finalized your house plans and are working with a builder – then a construction loan likely is what you’re ready for.
Construction loans typically fund the construction of custom or semi-custom homes from the ground up. When buying either a “Spec” home that already is built or when buying new homes from production builders, a buyer usually would not use a construction loan. In these transactions, if the builder is selling a completed home the borrower should only need a purchase money mortgage to buy the new home and the land on which it sits.
Home construction loans are unique products, and involve different paperwork, procedures and funding methods when compared to many other loan types. A significant difference is that home construction loans are short-term loans that are funded in periodic advances (or draws), so they are not fully funded at one time like at the loan closing for the purchase of a lot, land or existing home.
From a borrower’s perspective, and much like lot and land loans, construction loans usually are more difficult to obtain and will include less favorable financing terms when compared to a standard home mortgage. Be prepared to be faced with a larger amount of paperwork, additional transaction costs, a sizable down payment, a very short-term loan period and the possibility of higher interest rates (although monthly payments can be interest only during the construction phase). You likely will spend more of your time getting a construction loan processed and approved.
In the past, building a new home required two loans: the short-term construction loan for the construction phase and the long-term permanent mortgage (used to pay off the construction loan after the work was completed). This resulted in two closings, duplicate fees, high transaction costs and risks for the borrower about what happens when the construction loan matures.
Fortunately, the most common option today is the Construction-to-Permanent Loan (also called a “Single Closing” or “All-in-One” construction loan) that allows a borrower to have one loan, one closing and the construction loan simply converts to a long-term, permanent mortgage after the construction is completed.
Funds from a construction loan can help you build a home either on a lot you already own, or it can help finance the purchase of a new lot that you want to buy and then build on. If you already own your lot, your equity in the property can be included as part of the collateral for the construction loan. If you bought the land with a lot loan, then the construction loan typically would be used to payoff and refinance that first loan. If you are buying a lot with the construction loan you will coordinate the closing for the purchase of the lot with the construction loan closing.
Sometimes a homebuilder already owns lots and will offer to build a turnkey, finished home for a buyer on one of its lots. For builder-owned lots like this, the arrangement with the builder and the type of loan can vary. In some circumstances a buyer would need to get a construction loan up front, and buy the lot from the builder at the construction loan closing. But in other cases a builder with a builder-owned lot may fund the work and the buyer uses a purchase money mortgage to buy the home from the builder after the residence is completed.
If you are ready to start building your new home from the ground up it is likely that a construction loan is what you will need – whether or not you already own your lot free and clear, you bought your lot with a land loan or you are buying your lot with the construction loan. Read more details about how home construction loans work.
Finding a Lender & Related Considerations
The economic downturn and crash of the housing market continues to affect the availability of financing. Indeed, the market for purchase money mortgages for buying new homes – the typical, conventional mortgage – still is in flux and continues to make it difficult for many buyers of existing homes to get loans. These difficulties are amplified for the non-conventional lot loans, land loans and construction loans and this type of financing may not even be available in some markets. But the housing and lending markets steadily have been improving and these issues will continue to work themselves out as time goes on.
If you are ready to move forward with obtaining financing, then test the waters and see what options you will have. It goes without saying that you should make sure your financial house is in order so that you can make your loan look attractive to lenders.
Early in the process you should try to find a lender or mortgage broker that understands your needs and has experience in the type of loan that you are seeking. Getting pre-qualified will help you understand your budget and other financial limitations. Not all lenders or mortgage brokers work with loans for vacant land, so make sure you are partnering with someone who has the expertise, network and resources to deliver.
If working directly with a lender, be aware that it may be more difficult to get these kinds of loans from big banks. Consider working with a local community bank or credit union that may be more willing to fund these types of loans for properties in their area. Evaluate other lending options too, like VA Loans that can be used for new home construction or lot purchases, as well as potential local and state government-managed lending programs.
An experienced mortgage broker may have more loan options than a regular bank since they usually work with dozens of lending institutions across the country. Because of their variety of lending sources, a mortgage broker often can get you a better loan deal than if you contacted your local bank directly.
If you are unable to get a loan from a traditional lender, mortgage broker or government program, consider alternative strategies. Some borrowers look to cash, loans from family members and home equity loans from their existing residence to fund the purchase of a lot. Seller financing is another attractive possibility, as many motivated land sellers may be willing to allow you to finance your purchase with them instead of making you come up with the full price at the time of the purchase. Some borrowers try to sell their existing home first and then rent a home so that they can more easily afford a lot purchase loan or construction loan.
Whether you are considering a loan to purchase a lot, a loan to buy vacant land or a construction loan for building your new home on a lot of your choosing, hopefully this article will help you understand your options. And if you’re ready to find the right lot or vacant land for you, LotNetwork.com has over 250,000 lot and land listings nationwide that you can search to find that property.
Read our Resources for Buying Lots & Land and our series of articles about the 8 Tips for Buying Lots and Land, so you can evaluate your needs and do your due diligence up front before buying property for a new home.
And check out our resource pages with tips and information on the following topics:
- Land & Lot Loans: The Dirt on Financing Your Property Purchase — lotnetwork.com
- Construction Loans: Financing Your New Home from the Ground Up — lotnetwork.com
- Why do Banks Treat Lot and Land Loans Differently? — lotnetwork.com
- 8 Tips for Buying Residential Lots & Land for a New Home — lotnetwork.com