Unlocking Construction Mortgages: Understanding The Role Of Equity

Construction loans are a type of financing that funds the building of a residential home, from the land purchase to the finished structure. They are typically short-term loans with varying rates and repayment requirements that differ from traditional mortgages. One key difference is that construction loans are distributed in stages as work progresses, while mortgages provide funds as a lump-sum payment. Construction loans can be challenging to obtain without a banking history due to a lack of collateral, and borrowers may need to provide substantial down payments, typically ranging from 20% to 30%. An alternative to construction loans is using land equity to secure financing. This involves using the equity in one's land as collateral for a loan or as a down payment on a construction loan. However, it's important to carefully consider the potential risks, such as losing both the home and land in the event of default. Additionally, factors like the value of the land, sales price of the home, credit score, and loan programs will impact the use of land equity for financing.

Using land equity as collateral for a construction loan

If you own a piece of land and are looking to build on it, you may be able to use its equity as collateral for a construction loan. Construction loans are short-term loans that fund the building of a residential home, from the land purchase to the finished structure. They are typically paid out in stages as the work progresses and only require the borrower to make interest payments during the construction stage.

When using land equity as collateral, it is important to note that the value of your land is not based solely on its size. Other factors such as road frontage, usable area, soil conditions, and access to utilities will also play a role in determining its value. You will need to get your land appraised to understand its value and the loan amount you can qualify for. The lender may also inspect the land to get their own estimated value.

To use your land equity as collateral, you will typically need to own the land outright, with no outstanding mortgages or liens. Some lenders may still accept your equity as collateral if you have a land loan, but it may be more difficult to find a lender. It is recommended to work with a lender that has experience with residential construction financing and to shop around for the best rates and terms.

Using land as collateral for a construction loan can provide several benefits. It allows you to take out a loan without risking other important assets like your home, car, or savings. Land equity loans also tend to have lower interest rates and can be used for any purpose, giving you flexibility in how you use the funds. However, it is important to consider the risks as well. If you default on the loan, you could lose the land to foreclosure. Additionally, construction projects can sometimes be stalled or go over budget, so it is crucial to ensure you can afford the loan payments and construction costs simultaneously.

Differences between construction loans and mortgages

Construction loans and mortgages are two different types of financing that serve distinct purposes. A construction loan is used to fund the building of a new home, while a mortgage allows homeowners to purchase an existing, already constructed home.

Construction loans are short-term loans, typically with a term of one year or less, that cover the cost of constructing a new home. They are designed to last only as long as the construction project takes to complete, and as such, they are riskier for lenders as there is no finished product to serve as collateral for the funds. Construction loans are disbursed in stages as the construction progresses, with the borrower only paying interest on the amount disbursed. The borrower must also submit detailed information about the planned construction, including house plans, builder contracts, and project budgets. Construction loans may require higher interest rates and larger down payments to mitigate the risk for lenders.

On the other hand, mortgages are long-term loans, typically with a term of 15 to 30 years. They are used to finance homes that are already built and livable. Mortgages are secured by the home being purchased, which acts as collateral for the loan. If the borrower defaults on their payments, the lender can seize the property. With a mortgage, the borrower repays the principal and interest, as well as property taxes and homeowner's insurance, from the beginning of the loan term.

It is important to note that borrowers who finance the building of a new home with a construction loan may convert it into a mortgage loan once the construction is complete. This is known as a construction-to-permanent loan. Additionally, land can be used as equity for a construction loan if it is owned outright, with no mortgages or liens. The value of the land, the sales price of the home to be built, and the borrower's credit history will determine the amount of equity that can be used.

Construction-to-permanent financing

To apply for a construction-to-permanent loan, borrowers will need to provide documentation related to the construction, such as the contract signed with the builder, construction plans, specifications and builder contracts. The lender will also review the borrower's income, assets, debts and credit history, as well as order an appraisal.

Owner-builder loans

Construction loans are a way to fund the building of a residential home, from the land purchase to the finished structure. One type of construction loan is the owner-builder loan, which is a construction-to-permanent or construction-only loan where the borrower also acts as the home builder.

Most lenders are hesitant to allow borrowers to act as their own builders due to the complexity of constructing a home and the experience required to comply with building codes. However, some lenders do offer owner-builder loans, which typically have a 12-month term. These loans are usually interest-only during the construction phase, with monthly payments calculated from the date of each draw.

To qualify for an owner-builder loan, you will need to meet the lender's requirements, which may include providing documentation on your experience in residential building projects, proof of insurance, and banking references. The lender may also require an accurate budget for the project, which you can develop with the help of a contractor and a residential construction lender.

When using land as collateral for an owner-builder loan, you may need to provide additional supporting documentation, such as the land deed and any deed restrictions. The value of your land, the sales price of the home you wish to build, your credit score, and the loan programs you qualify for will all be determining factors in the loan amount and terms.

It is important to shop around for rates and get pre-approval for your owner-builder loan to ensure you can borrow enough to build your home. Additionally, consider taking an online course to learn how to stay organized, on budget, and on time during the construction process.

Land equity loan types

Land equity loans allow you to borrow money against the value of land that you own. They are best for those who already own land and want to either acquire more (especially rural land) or finance land improvements. Using your land as collateral, you can obtain a loan without risking other assets, such as your home or stock investments.

There are several types of land equity loans:

• Land equity line of credit: Similar to a home equity line of credit (HELOC), this type of loan allows you to access credit as needed and only pay interest on what you borrow.
• Land equity cash-out refinance: This option allows you to take out a new loan that is larger than your current loan balance. You pay off the original loan and keep the difference. This can potentially lower your monthly payments and lock in a lower interest rate.
• Guarantor loan: This type of loan involves using a guarantor, typically a family member, who uses their real estate as additional security for your loan.
• One-time close construction loans: Also known as "all-in-one" or "construction-to-permanent" loans, these loans are a popular way to use land equity to build a new home. They combine the features of a construction loan and a traditional mortgage, providing funds for both the construction phase and the completed structure.

The amount you can borrow with a land equity loan depends on various factors, including the value of your land, your credit score, and the intended use of the funds. Lenders will typically send an appraiser to evaluate your property and determine its value. The loan amount and terms may also be influenced by the purpose of the loan, your income, and the asset being used as collateral.

Frequently asked questions