Lot and Construction Loans: What You Need to Know

You may need up to three different types of loans for your custom home build. Here’s how they work.

Lot Loans

Lot loans, also called land loans, are short-term loans to help you purchase land for your new custom home. A lot loan may have an adjustable or fixed interest rate, and your payments may be interest-only or principal plus interest.

Lenders vary considerably on loan dollar-amount limits, lot size (acreage), and which type of lot/land you can purchase. Most lenders require that the lot is located in a residential area and may not lend for an undeveloped (raw) property. Raw, undeveloped land is riskier for banks. Residentially zoned property is more viable for homebuilding; more likely to have utilities (water, electricity, sewer), and a road, nearby that you can connect to.

Your lender may agree to let you apply for 2 loans, the lot loan and construction loan, at the same time. The lender might also take an application all 3 loans at once, (lot, construction, and home mortgage loans) with a single closing, which can save your time, hassle and money on closing costs.

Instead of a traditional bank or lender, some land buyers use a home equity loan (against the equity of another property they own) to purchase their new lot. Others may find a lot where seller financing is offered.

Construction Loans

Construction loans are short-term loans for real estate construction and/or buying land. A construction loan functions like a line of credit, because only a portion of the total approved fund is paid out, for each phase of the custom home building project.

That means you only pay interest on the amount paid out, rather than paying interest on the whole amount right away, as you would in a regular mortgage to purchase an existing home. For a construction loan, you generally make interest-only payments (or none at all) on the part of your balance that has been paid out so far (the outstanding balance).

Either you or the builder can request payment for each completed phase of the home building work. Before releasing each pay-out, the work must be inspected to assure the bank it has been done.

How to Qualify for a Construction Loan

Like most loans, you need good credit and you’ll need to prove acceptable, consistent income. The lender will use calculations of your debt-to-income and loan-to-value to determine the amount for which you qualify. Lenders typically ask for a 20% down payment, or you might use land you own as collateral.

Here is where the construction loan differs from other types you may be familiar with. The lender will want to review and approve your construction plans. An experienced builder will be able to submit proper plans and architectural drawings, and may even have a pre-existing relationship with a specific bank or alternative lender. This could help your construction loan approval go faster.

Your builder must also provide the lending institution with a schedule, listing each construction milestone, along with projected costs. Lenders will often insist that the homeowner set aside extra money to pay extra costs that may come up during construction (over the pre-construction cost estimate), because cost overruns could then exceed your pre-approved loan amount.

Finally, the builder will have to affirm that the new custom home will be built to meet local building codes and municipal regulations. This means that the builder will pull all needed permits, and construction work will pass city/state inspections. Paperwork submitted with your loan application must also provide an estimated home value of your completed custom home.

Construction-to-Permanent Loans: Applying for Temporary and Permanent Loans Together

Construction loans are generally taken out for a short term with a variable interest rate. Construction loans are sometimes referred to as temporary, because they are used only during construction and must be paid off upon completion of the custom home build. The loan term is well under one year. Once construction is complete, you’ll refinance and pay off the construction loan–with a new fixed-rate or variable-rate mortgage. The mortgage approval is dependent upon a home inspection and appraisal of the newly completed custom home and property.

Construction-to-permanent loans are popular because you can save on closing costs by applying for (and closing on) both the short-term construction loan and the long-term home mortgage at the same time. This single application/closing also saves you the hassle of re-applying for a mortgage after the construction is finished. Consider asking your lender to lock in the mortgage rate when construction begins. They may slightly increase your mortgage rate, but you could save money, if home loan rates rise while your custom home construction is ongoing.

When You May Need a Stand-Alone Construction Loan: Getting a Home Mortgage After Construction is Complete

In some cases, the single construction-to-perm loan is not possible, or may not be the best option:

  • VA and FHA Mortgages: Some lenders don’t allow the combined loan with VA or FHA. If you use the stand-alone construction loan, then apply separately for the mortgage, you will once again have to submit new documentation of your income and good credit score, etc., to get the “traditional” mortgage after construction. The mortgage may be a 30-year (or 15-year) mortgage. 
  • Selling your current home: For clients who are selling an existing residence, to make a higher down payment on their new custom home, a stand-alone construction loan could be the preferred way to go.

How An Established Home Builder Can Help Make Applying for Your Loans Easier

Each bank, credit union or alternative lender has slightly different rules, so your process may be a bit different. Your builder may be able to recommend a lender with whom they have a relationship, and may have insights into the specific process that lender uses.

As an experienced design/build firm, Miller’s Residential Creations understands exactly which documents, estimates, and house plans they must submit to the lender to help you satisfy requirements.

Contact Miller’s Residential Creations today, to start planning your dream home.

Brian Miller is the owner of Miller's Residential Creations, a custom home builder and remodeling company servicing Berkeley, Jefferson and Morgan Counties of West Virginia since 2004.
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