Building Your Dream Home: Part 4 - Paying for Land and Construction

Buying a house can be stressful enough. Buying land on which to build a house has its own many challenges. Yet these should not inhibit anyone who has the means to pursue a dream…and a little piece of earth to make it all happen. Key to a successful land purchase and residential construction is remembering that land value and home value complement one another. Therefore, making the investment can pay enormous dividends when the time comes for resale. How, though, is raw land purchased? Just as pertinent, how is new home construction financed? Knowing these things sharply reduces stress.

Vacant Land: A Question of Collateral

Lenders that advance funds for raw land take a greater risk than those that stick to pre-existing homes. The latter name the structure as collateral, i.e. something of value put up for security in case the borrower defaults. So, if the home owner stops making payments, the bank or finance company will initiate foreclosure to seize the property. Vacant land without any improvement has no home value against which a lender can leverage. This is not to say financing is not available – you might just have to work a little harder at getting it.

Unless the buyer can pay all cash for the property, the most inexpensive options for financing include:

Seller financing – whereby the purchaser acquires the land, repaying the seller principal and interest according to an agreed-upon schedule. Down payment is likewise subject to mutual decision. If the seller is highly motivated, the terms can be attractive. Although this is a private arrangement, it is best to retain an attorney for this agreement.

Community banks and credit unions – while not sure bets, are far more likely to give an application a fair shake than the national mega-lenders. Being relatively local, they possess greater familiarity with the surrounding area. Those that bank with them have an edge, obviously. However, they not only want to see low risk in borrowers, they also may ask for specifications and design plans for the proposed house.

United States Department of Agriculture (USDA) – is not just about farm subsidies and meat inspection. This agency invests in rural development as well. If, then, the land sought is a little farther from civilization than the typical suburban lot, buyers might just find a reasonable loan from the USDA.

Getting a Construction Loan

Assuming you already hold deed to the land, the construction loan is a short-term (one year) advance that covers materials, labor and – if necessary – the use of heavy equipment to make the land hospitable to the home design. Construction lenders prefer the use of a reputable builder as opposed to DIY jobs so self-reliant sorts may encounter difficulty getting financing. Most banks insist on the submission of detailed construction plans, price estimates and timelines before approving any application – the more detail, the better (e.g. floor plans, materials lists etc). The requested loan amount should cover more than the contractor’s estimate. There should be a cushion in the event of unforeseen expenses.

How the Loan Works

As noted, this kind of loan is short-term…until it becomes long-term. During the short-term phase, the lender will issue funds according to a draw schedule submitted with the loan application by the builder. The borrower makes interest only payments (at a variable rate) until the home is completed and inspected. Often, lender representatives will monitor construction progress. Once the building is ready for occupancy, the loan converts to a traditional mortgage – often a fixed-rate product for 15 to 30 years.