The world of home financing can be oh-so-confusing, especially when you are looking to buy a lot and build a custom home. In this article, we look at the types of loans available and help you figure out which one is best for your circumstances. On top of that, we outline what you’ll need to get preapproval for the kind of loan you want. Let’s get started!
Lot or Land Loans
If you have already found the piece of land you want to buy and know that it will be several years before you start building, a lot or land loan is the best option. Actually, the best option is to pay cash since obtaining this kind of loan can be difficult and have unfavorable terms, but sometimes it is necessary to go this route. Be prepared to see shorter-term loans, higher down payments (around 30 percent), higher interest rates and additional borrower commitments and underwriting.
“Owners of raw land are much more likely to stop making payments and walk away from the property in the event of a financial event in their lives,” says Casey Fleming, a mortgage adviser with C2 Financial Corporation.“And land is much harder to sell [than a home].”Many lenders do not even offer lot loans, and community banks and local credit unions can be a better bet than large national banks. As with any loan, be sure to shop around so you can compare all of the offers available to you.
When you are ready to build on already purchased land or if you want to buy a lot and build right away, you will need to apply for a construction loan. If you already own the land, the equity can be used as collateral to help finance a construction loan, or you may also be able to use a current home as collateral.
Sidney Potter, owner of Potter Equities and author of The Flip, suggests finding “a very experienced construction loan broker; they are a slightly different breed from typical mortgage loan officers because they specialize in this area.”
Two kinds of construction loans are generally available to borrowers:
This type of loan structure used to be the primary way to finance building a custom home. Two loans were necessary: a short-term construction loan for the construction phase, followed by a long-term “end loan” to pay off the construction loan. Essentially, you refinance the construction loan and enter into a new loan (aka mortgage) for the completed home. In other words, you undergo two closings and risk receiving unfavorable terms for the second loan due to rising interest rates. Potential benefits include lower rates (but this is not guaranteed) and more flexibility since you can pick and choose rather than go with a package loan deal. While this type of loan scenario is still possible, lenders have developed another solution for borrowers known as “construction-to-permanent,” “single close,” or “all-in-one” loans.
Instead of two separate loans, lenders now offer package deals with all of the terms for the short-term construction loan and the mortgage loan set in advance. The construction loan is converted to a long-term, permanent mortgage after the construction is completed, meaning there is just one loan and one closing. Mortgage expert Joey Campbell explains, “The construction-to-perm loan allows you to modify your construction loan to the permanent stage, which can be any term that you chose when the construction-to-perm lender offered it to you at the beginning of the construction stage. You normally do not have to requalify for the permanent loan.”
For either type of loan, the lender does not simply hand over a lump sum. Instead, a schedule of draws is created so that when certain milestones in the construction process are reached, the lender issues the funds for the next portion of construction. The first draw usually comes from the buyer’s down payment, and the bank usually sends an inspector at each stage before releasing the next draw to the builder. All of these safeguards reduce the risk of financial loss for the lender.
The Preapproval Process
If you know that you will need to secure a loan for the land or construction, it’s best to prepare yourself financially and obtain preapproval. This is what you will need, at a minimum:
For a Lot/Land Loan
- A large down payment of 20 to 30 percent
- A good credit score
- Low debt-to-income ratio
- Cash reserves
For a Construction Loan
All the above, plus:
- A qualified, licensed builder with a good track record
- Detailed specifications about the custom home, including expected project costs
- Home value (based on the plans) estimated by an appraiser
One way to potentially get better interest rates (and a quicker approval process) is to work with a builder before buying a piece of land. Visit the Custom Builders section of NewHomeSource.com to find a custom builder today.
For the last 16 years, Rachel Kinbar has been a writer of articles, blog posts, white papers, essays, infographics, web copy, sales copy, scripts, poetry, lyrics, and more. She has keen research skills that she applies to a wide variety of topics, and she especially loves topics related to design, history, and sustainable living.