Homeownership remains a goal for many Americans. For some, though, it’s not enough to purchase an already-built home. Some would-be homeowners want to build a dream home.
If you’re interested in buying land and building a house but you’re wondering how to get the money to do it, it’s important to realize that the financing process for new construction can be different than buying an existing home using a traditional mortgage loan. In fact, it can be a bit more complicated, but you shouldn’t necessarily let that stop you.
Here’s what you need to know about getting the money you need to build your dream home.
What is a construction loan?
First of all, if you’re buying land and building a house and you need financing to do so, you’re going to need what’s known as a construction loan. It’s important to note that a construction loan is different from a lot loan or a land loan. With a lot loan or land loan, you’re just buying raw land. You need to get a separate loan to cover the cost of building the house — and this is where the construction loan typically comes in.
The construction loan is used to actually build the house, and the money is often disbursed in phases as the home is built over time. Construction loans also usually are relatively short-term loans and might need to be paid off within two years. It’s common to apply for a home mortgage to pay off the construction loan if you can’t afford to pay it off at the end of such a short period of time.
In some cases, it’s possible to roll the construction loan into a traditional home loan once the house is built. If this is the plan with your lender from the start, then this is what’s known as a single-closing construction loan. This can simplify the process since you have one lender for 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 for use. 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 providing the financing for the next construction phase, there are inspections and walk-throughs. Additionally, the builder is required to get necessary permits and meet other requirements before they continue receiving funds.
On top of the disbursement coming in phases, you might also have to make payments on the loan during the building phase. Depending on the lender and the type of construction loan you get, you could begin making payments anywhere between six months and 24 months after the loan is originally made. In some cases, you might only need to make interest payments until the house is completed.
Once the home is finished, the loan might be turned into a mortgage, or you might be expected to pay off the loan in full. Most people will apply for a regular mortgage at this point if they are required to pay off the loan in full. That mortgage is then used to pay off the construction loan and possibly the vacant land loan, and you make regular monthly payments on your mortgage moving forward.
Qualifying for a construction loan
Any time you’re trying to figure out how to get a loan, you need to be aware of qualifying criteria. Every loan is different, and that goes for home loans too. Because a construction loan is often considered high risk, it can be a little harder to qualify.
In fact, you probably need between 20% and 25% for a down payment and a credit score of at least 620. This is in contrast with conventional mortgages, where you might be able to get a loan with 3% down. If you get an FHA loan, you could potentially qualify with a credit score as low as 580. As a result, when you’re calculating how to save for a house you’re building, you might need to plan for a larger amount.
Be aware that even though there are higher qualification requirements for a construction loan, you’ll still 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.
The application process is more complicated than a traditional mortgage as well. Your application has to include information about your contractor and builder, as well as your projected schedule and construction plans.
When you apply for a construction loan, the lender is not just evaluating you as the borrower — the builder is being evaluated 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
As you consider the type of loan that will work best for you, it’s important to consider your options carefully. In addition to traditional lenders, there are a few different government loan programs that might work for your circumstances.
With a traditional lender, you usually need at least 20% down to qualify for a 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, 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 Veterans Administration, it’s possible to build a house — and to do so without needing 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 come with mortgage insurance premiums if you put down less than 20%. However, there is usually a VA funding fee in addition to any closing costs your lender might charge.
If you qualify as a veteran and have your Certificate of Eligibility, you might be able to run the numbers and find that a VA loan meets your needs.
FHA construction loan
For buying land and building a house, an FHA One-Time Close Loan might work for you. This is one way to buy the land and cover construction costs in a single mortgage.
As with other FHA loans, it’s possible to get a mortgage with a down payment of 3.5%. Additionally, the debt-to-income ratio of up to 50% and the lower credit score requirements can make it easier to qualify for an FHA loan than for a traditional construction loan.
USDA guaranteed loan
For those who live in places considered rural areas, it might be possible to get a single-close loan that includes both construction and vacant land costs through the U.S. Department of Agriculture. USDA guaranteed loans are generally easier to get, with a debt-to-income ratio requirement of up to 50%. Additionally, you might not need to make a down payment with a USDA loan.
Be aware, though, that you do pay mortgage insurance with one of these loans. Additionally, you 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, it’s also possible to use other types of financing to buy land and build a house.
Using your home equity — if you currently own a home
If you already have a home and you have a lot of equity, you might be able to pull equity from that home to finance your dream home. You’ll have to qualify for the home equity loan. Yet once you have the necessary funds, you can buy a piece of land and then start building a home.
However, you might end up having to sell your first home to pay off the home equity loan if you can’t keep up with the monthly payments. Another option is to rent out your first home and use that to cover your costs.
Another option is to ask if you can get financing from the land seller. You might be able to get this type of private financing if you have poor credit or can’t meet the down payment requirements from a traditional lender. As long as the seller is willing to allow you to make payments to them as agreed, you might be able to get a land loan that works better for you.
However, you’re still vulnerable to foreclosure if you can’t make payments. Additionally, you might end up paying a higher interest rate since the seller is personally taking on the risk that you won’t make all the payments. This also won’t cover the costs of the home construction so it’s not a good idea if you want to build right away.
Buying a teardown — demolish an existing home and build a new one
With a teardown loan, you buy an existing home on a lot and then demolish it. You build a new home in its place. If you’re planning a teardown, there might be other complexities involved with the mortgage process. Yet, if you’re having trouble getting loans to buy land and build, a teardown can make it a little easier.
However, it’s important to note that sometimes these loans are short-term and require a conventional mortgage at the end in order to pay them off — similar to a construction loan. Some lenders do offer loans that wrap everything into one loan, but you might have some difficulty getting these loans.
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 620 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 land loan on just the land. While not as many banks issue land loans as home loans, you can often find lenders in your particular region. You may want to check out local credit unions and community banks in particular. The nice part about buying just land is that you can then decide whether to build on it later.
Buying land and building a house with financing can be a more involved and difficult process than purchasing an existing home. Whether you’re buying or building, make sure to understand the various myths about homebuying, so you don’t run into trouble.
And before you move forward, be sure to run the numbers, make sure you meet the qualifications, and carefully consider whether buying land and building your own home will help you meet your goals.