Land and construction loans: how does this work?

olivesmomMarch 29, 2013

If we were to purchase a lot using owner financing and a few years down the road (while the lot is still being owner financed) we decide we want to build on it, how would that work? Would the lender issuing the construction loan essentially refinance the lot?

I ask because we have decided on a specific neighborhood we want to build in. Previously we were looking at totally undeveloped lots in a more rural area, but recently we fell in love with an estate lot sort of neighborhood with large homes on 2-5 acres. The neighborhood is mostly built out, but there are a few lots left. One of which is offering owner financing.

Also, if we decide to wait and not opt for owner financing, is it any easier to get a land loan on a neighborhood sort of lot that is more developed in terms of utilities and critical areas/wet lands?

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I know you mentioned "owner financing" but I tend to be leery (both as a buyer and as a seller) of owner-finance deals. Do read the link below.

We bought the land for our current dream house about five years in advance of starting to build our house so I learned a few things along the way that might be helpful to you and may suggest another avenue for you to follow.

First and foremost, land only loans are notoriously hard to get - even for property within a neighborhood that is already developed in terms of utilities. There just are not that many lending institutions that make land-only loans. Plus, the interest on land-only loans is MUCH higher than on practically every other kind of loan.

In 2003, we bought 4 acres in a development that, I suspect, is very similar to the one you're describing. Price was right at $50K for the 4 acres. In 2003 mortgage and construction loans for those with good credit were running around 4.5 to 5%, and we could get a loan to buy a car or even a motorcycle for about 7%. But every place we asked about a land only loan wanted 8.5% or more!

I have no clue why this is. It's not like one can abscond with a piece of land, or wreck it in a crash and then refuse to finish paying it off. But that's the way the market is.

On an owner finance for a land-only deal, I would not be at all surprised if the seller wanted a percentage point or two above what banks are currently asking for on land only loans. After all, if the seller originally purchased the land by taking a land-only loan and still owes something on that loan, he's going to want to get enough to pay back his own loan plus make something for his trouble.

When we decided to buy our new land, we already owned a home and had significant equity in it. So we realized that we could do "equity out" refinance on our first home and use the money to buy our land out-right. Because interest rates had fallen significantly since we'd first purchased our house 18 years previously (a 30 year flat rate), even after paying the fees to refinance, we actually came out ahead.

Our monthly payments stayed almost exactly the same (the difference was less than $10/month) and even though we had taken out $50,000 in equity, the total remaining pay-out period only changed from 12 years to 13.5 years. We then started making extra payments each month and actually finished paying off the original mortgage plus the additional $50K loan in just five years more years.

So the upshot is that we basically got to "borrow" the $50K to buy our land for free.

So, if you already own a home and have equity there, you might look into a home equity loan instead of an expensive land loan or taking the risks associated with an owner-finance deal.

The other thing is that, when you are ready to start building, the bank that makes your construction loan is going to insist on having foreclosure rights on the land the house will sit on as well. (That's reasonable since it would be pretty much impossible to foreclose on a house without foreclosing on the land it sits on!) And the bank is NOT going to want to be the junior lien holder on the land. So yes, you will have to finish paying off your land loan either before - or concurrently - with getting your construction loan.

Whether a bank will loan you enough to pay off the land AND build the house you want is pretty problematic. Banks now typically will only loan 70% of the value of the finished property (house and land) and they expect the homeowner to put down the other 30%. If you own the land free and clear when you go to borrow construction money, you can claim its value as part of your 30%.

If you still owe money on the land, then you are going to have to ask for a bigger loan (so you can pay off the land) and will have less equity to apply to your 30%.

The bank that is going to make your construction loan won't care if you pulled some of your equity out of a previously owned house in order to buy the land outright. As long as you own the land free and clear, it's value can count toward the 30% you'll need to put into the new deal.

Of course, one of the questions the bank WILL ask in determining how much of a loan you can qualify for, is how much you are currently spending on mortgage payments on unrelated property. But they don't care how much or how little equity you have in the unrelated property because they can't foreclose on that property if you fail to make your payments on the new place.

Anyway, it's just an idea. It worked very well for us and might work for you.

Here is a link that might be useful: Pros and cons of owner financing for buyers.

    Bookmark   March 29, 2013 at 4:58PM
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Thank you Bevangel.

The original developer of the neighborhood owns the land. It is a nice lot, in a very nice neighborhood and is pretty expensive (to me anyway). 325K for a little over 4 acres. They may be asking too much, I don't know as it is hard to say. It is the only lot in the neighborhood on the market. There may be one or two other lots that are vacant, but they aren't listed.

Almost in the same neighborhood, but not quite, are two other lots. One bank owned one for 175K I think and another for 225K. Both are closer to two acres. They are in a gated neighborhood as well but it isn't as nice (landscaping and street layout) as the first neighborhood.

Anyway, the owner financing for the lot might be our only option. 30% down is required. We like the lot A LOT, but the price is hard to swallow. Resales in the neighborhood have sold for about 650-675K, mostly 2-3 acre lots. Nice homes (~4,000+ sq ft) built around 2005-2008. It will cost us much more to build a similar house. It would probably be wise to just purchase a resale, but this will be our "forever" home and I'm not sure I want to live with someone else's custom choices forever.

So if we purchased the lot using the owner financing we would hopefully build a few years later and I'm doubtful that we could have the lot paid off by then. And as far as equity in our current home, nonexistent. If prices don't fall any further then we should be at a break even point in a few years. We plan to hold onto the house and rent it out once we ever move. We should be okay, DTI-wise, even with future construction loan + existing mtg payment.

The price of the lot makes me nervous as does uncertainty about getting a construction loan down the road. We could of course just wait until we have the construction loan approval, but that looks to be a few years away and this may be the last lot left in THE neighborhood we want. Neighborhoods like this are very rare where I live. Despite living in a far out suburb, but most homes (even 3,000 + sq ft ones) are built on microscopic lots.

This lot has been on the market for almost two years and with its high price in comparison to the existing resales, I don't think it is going anywhere soon. We don't have the 30% down anyhow, maybe in six months? We will see.

    Bookmark   March 29, 2013 at 5:47PM
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You should talk to several lenders in your area to find out, first hand, what the loan conditions are for your location. There is considerable variation across the U.S. (and Canada, I presume).

The idea of using existing home equity to purchase the land is a good one, if you are really serious and plan to build in the near term. And if you can pay cash for the land, that is another good scenario.

This is part of the exploration you should pursue with lenders.

Whatever you do, don't rush into anything without first doing your due diligence.

Good luck with your project.

    Bookmark   March 29, 2013 at 6:21PM
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My wife and I just secured a land / lot loan in the suburbs of Cleveland, OH. We encountered a similar situation where we wanted to buy a lot (1.18 acres) in a specific neighborhood and encountered a great price from the developer because he was a "friend-of-a-friend". We do not plan to build on the land for a minimum of 1 year, so the lot loan was the only way for us to do it.

I should also specify that we never bought previous real estate or ever owned our own home. In other words, utilizing previous equity was not an option for us.

We were able to secure the lot loan with 20% down with a 5/1 ARM at a 25 year term. I think our rate is 4.8.

We didn't really care about the ARM aspect because we plan to roll our lot loan into a construction loan or work out a deal with a local custom builder.

Here is what was explained to us by the bank when we talked to them about lot loans / construction loans.

In our area, it is typical that a lot loan can be bought out with a construction loan and then the construction loan would convert to a permanent loan after the home is built. The bank we utilized for our lot loan also offers construction loans, so perhaps that is a specific benefit doing both loans from the same bank.

The second option we were told about from our bank may be specific to our area (but worth looking into). Some custom builders have the ability to fund the construction loan themselves, will buy the land from you, clearing the lot loan, and then sell the whole home and price of land to you at the end of the process. Of course this option would require letters from the bank to the builder telling them your qualified amount and that the bank will give them a check at the end of construction.

This would allow you to take out a more traditional mortgage instead of a construction loan. The reason we discussed this option with the bank was because we were interested in a physician-specific mortgage instead of a construction loan.

It really depends on what you can work out with builders and your bank in your area. Once we get to the construction stage, we may very well utilize a construction loan instead of a physician-specific mortgage.

    Bookmark   May 2, 2013 at 10:20AM
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Going through the exact same process now on a 3 acre lot very close to a major metro (not cheap). We plan to break ground in 18 months. We have cash saved up for the lot, but if we can't negotiate the price down we will be a little short. The first bank I talked to quoted an 18-24 month term. That's a pretty steep payment, so good to hear that longer terms are available!

Given the insane run the market is making right now, I'd rather keep my money in the market and make payments on the lot loan. Risky, but quite painful to put all that cash into an asset that won't gain value in the next 18 months.

    Bookmark   May 3, 2013 at 11:55AM
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We purchased a 3 acre lot in Minnesota last year, 10% down, 3 year balloon with payment based on 30 year amortization, 6.9% interest rate. We didn’t care about the 3 year balloon as the bank could modify the loan for an additional 3 years for a fee and we were planning to build within a year of purchase, breaking ground in June.

Definitely shop around with several local banks and credit unions, they were our only option for financing. Almost all the local banks and credit unions had financing options for a lot purchase while the large national banks didn’t.

    Bookmark   May 3, 2013 at 1:35PM
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We didn't have a hard time with our land loan, but it was 10 acres, so we ended up using a farm credit service. I believe they required 20 percent down. (I've heard land loans are difficult because if you have to choose between paying for your mortgage or your vacant land, most people aren't going to choose the vacant land.)

When we build, the balance on our land loan will be rolled into the mortgage on our new house. We are also going to use some of the equity we have in it toward our down payment.

    Bookmark   May 4, 2013 at 1:13PM
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We went through a similar process and live in King County. I think you live somewhere nearby or at least were previously shopping nearby. We did owner financing as part of our offer but once we figured we were going to immediately start financing paperwork we made a lower cashout offer and went that direction. Homestreet had the best deal for us on the construction loan and we tried quite a few lenders who did construction loans. Before you build you will have to have it paid off in my experience. I wouldn't commit to the 30% down and pay on land you may not be able to afford to build on later if cashing out doesn't seem feasible. I don't want to sound negative but the above poster is correct, you will not find a bank that will be anything other than #1 lein holder.

    Bookmark   March 24, 2014 at 8:52PM
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