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There’s something to be said about the dream of buying land and building a house: You get to choose the terrain and build your home just the way you want it. But unlike buying an existing home with a traditional mortgage, you’ll likely need to finance new construction a little differently.
Here’s what you need to know about getting the money you need to build your dream home.
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What is a construction loan?
To buy land and build a house, you’ll probably want to use a construction loan. Construction loans let you finance the purchase of the land and the construction of a home with one loan. They’re different from lot loans or land loans, which only finance the purchase of raw land. Instead of financing the land and then financing the construction separately, you can roll both processes into a construction-to-permanent loan. If you already own the land, you can use a stand-alone construction loan to only finance building the home.
Construction loans are typically short-term loans with repayment terms of between six months and two years — just long enough for the home to be built. Your lender will typically disburse the funds periodically as the homebuilders reach certain milestones in constructing the home.
At the end of the term, most people either pay off the construction loan or roll it into a new mortgage on the newly constructed home. If this is the plan with your lender from the start, then this is what’s known as a single-close construction loan. This can simplify the process since you have one lender for both the short-term construction loan and the long-term mortgage.
The best mortgage lenders can offer you a variety of loan options and help you understand the different types of construction loans.
How construction loans work
When getting a construction loan, it’s important to note that you won’t receive one lump sum. Instead, the lender typically has access to the home construction plans and disburses a percentage of the loan funds at different stages of construction. Before the lender provides the funds for the next construction phase, all necessary permits, inspections, and walk-throughs must be completed and filed.
Depending on the lender and the type of construction loan, you may need to begin repayment while the home is still being built. In some cases, you might make interest-only payments until the house is completed.
Once the home is finished, the loan could be converted into a mortgage, or you might be expected to pay off the loan in full. In that case, many people choose to pay the construction loan with a new mortgage. Then you simply make regular monthly payments on your mortgage moving forward.
Qualifying for a construction loan
If you want to know how to get a loan for your new build, you’ll need to find out what you need to qualify.
Construction loans are often considered higher-risk than other types of loans, and typically require:
- A down payment of 20% to 25%
- A good credit score (some lenders may require a minimum of 680 or 720)
- A steady income
- Detailed construction plans
In contrast, some conventional mortgages are available with as little as 3% down, and you could potentially qualify for an FHA loan with 3.5% down and a credit score of 580, or 10% down and a credit score of at least 500.
You’ll also probably pay a higher interest rate than what you’d see with a conventional mortgage. Plus, depending on the type of loan you get, you might end up paying additional fees, too.
The application process for a construction loan is typically more complicated than a traditional mortgage. Your application must include information about your contractor and builder, as well as details about your projected schedule and construction plans.
When you apply for a construction loan, the lender is not just evaluating you as the borrower — they’re evaluating the builder as well. You’re unlikely to get approved if you want to build a home yourself unless you’re already a licensed and experienced builder.
Types of construction loans
Options for construction loans include traditional lenders, such as banks and credit unions, as well as special government-backed programs. If you can qualify for a government-backed loan, you might enjoy a low down payment or no down payment at all.
Traditional lenders
With a traditional lender, you usually need at least 20% down to qualify for a construction loan. Additionally, you’ll probably pay a higher interest rate and have a number of restrictions on the builders you can use and the process that’s followed.
If you do want to act as your own general contractor and get an owner-builder loan, you’ll also have to show the lender that you have the necessary expertise and licenses to actually do the job.
These loans can be more expensive than traditional mortgages. For example, if you get a construction-only loan, you’ll probably need to get a mortgage later to pay off the construction loan. That means paying two sets of fees, as well as keeping up with the requirements for payouts.
Even a construction-to-permanent loan, which is a single loan that converts to a mortgage at the end of the homebuilding process, can be more expensive. These loans usually require interest-only payments during construction.
VA construction loan
For those who qualify for a loan backed by the Department of Veterans Affairs, it’s possible to build a house without a down payment.
On top of that, you might get a better interest rate than what’s offered by some traditional lenders. VA-backed home loans also don’t require mortgage insurance premiums or private mortgage insurance (PMI). Instead, there is usually a VA funding fee to pay in addition to any closing costs your lender might charge.
If you qualify as a veteran or service member and have your Certificate of Eligibility, run the numbers; you may find that a VA loan meets your needs.
FHA construction loan
An FHA One-Time Close Loan is another type of government-backed loan that might work for you, especially if you don’t have perfect credit or buckets of cash. This loan lets you buy the land and cover construction costs with a single mortgage. FHA loans have lower credit score requirements, which can make it easier to qualify than with a traditional construction loan.
As with other FHA loans, it’s possible to get this type of construction loan with a down payment of 3.5% and a debt-to-income ratio of up to 43%. You’ll still need to hire a licensed general contractor (or be one yourself) to build the home.
USDA guaranteed loan
If you want to build a home in an eligible low-density, rural area, you might consider a single-close loan through the U.S. Department of Agriculture. USDA-guaranteed loans are generally easier to qualify for than other loans, with no minimum credit score requirements, and allow a debt-to-income ratio of up to 41%. You might not need to make a down payment, either.
Be aware, though, that you do have to meet income requirements to qualify. The stated purpose of USDA loans is to help those with low to moderate incomes, so if you make more than 115% of the area’s median income, you won’t qualify for this type of financing.
Other financing options
If none of these programs sounds like it will work for you, you might consider other types of financing to buy land and build a house.
Using your current home’s equity
If you already own a home, you may be able to tap into your equity to build a new home. A home equity loan lets you borrow against the equity you’ve built in your home. With those funds, you could buy a piece of land and start building.
Make sure you can keep up with the monthly payments on your home equity loan, or you could be forced to sell to repay the debt. Another option is to rent out your first home and use that to cover your costs.
Seller financing
Seller financing is a type of private financing you get from the person selling the land. It may be the right choice if you have poor credit or can’t meet the down payment requirements from a traditional lender. Another option is called a land contract, where the seller retains ownership of the land until you make the final payment.
Seller financing has some drawbacks, however. You’re still vulnerable to foreclosure if you can’t make payments, and you might end up paying a higher interest rate to compensate for the risk the seller personally is taking on. Plus, seller-financed land still leaves you short on funds to cover the costs of home construction, so it’s not a good option if you want to build right away.
Buying a teardown
With a teardown loan, you buy an existing home and then demolish it to build a new home in its place. If you’re planning a teardown, there might be other complexities involved with the mortgage process. On the other hand, if you’re having trouble getting loans to buy land and build, buying a teardown can make the process a little easier.
However, it’s important to note that sometimes these loans are short-term and require a conventional mortgage at the end to pay them off, similar to a construction loan. Some lenders offer options that roll everything into one loan, but it can still be difficult to find and qualify for this type of loan.
FAQs
Is it smart to buy land and build a house?
Whether buying land and building a house is smart depends on your personal goals and financial situation. If you want to customize your home and you can afford some of the higher costs that can come with construction loans, it can be a smart move. Carefully consider your own personal finance situation before moving forward, so you have an idea of whether buying land and building a house makes sense for you.
What kind of credit score do I need to get a construction loan?
In general, you’re likely to need a credit score of at least 680 to get a construction loan. While you might be able to qualify for some loans with a lower credit score, you’re more likely to have success if you have a credit score in this range.
Can I get a mortgage on land only?
Yes, it’s possible to get a loan on just the land, though not as many banks issue land loans as home loans. Check out local credit unions and community banks in particular to find this type of loan. The nice part about buying just land is that you can decide whether to build on it later.
Bottom line
Buying land and building a house with financing can help you create your dream home, but it’s often more complex than buying an existing property. To maximize your chances of success, work on boosting both your savings and your credit score, and look for a qualified, licensed general contractor and builder to help you reach your goals.