Can You Buy Land With a Construction Loan?

A construction loan provides a specialized financial pathway for individuals looking to build a new home. Unlike a traditional mortgage, which finances the purchase of an existing property, a construction loan addresses the unique needs of a building project. This financing is structured to disburse funds as construction progresses, covering various stages of development. It serves as a temporary funding solution.

Understanding Construction Loans for Land and Build

Many construction loans are designed to encompass both land acquisition and the costs of constructing a residence. This integrated approach allows borrowers to finance the entire project, from lot purchase to the completed home, often within a single financial package.

Construction loans differ from standard mortgages due to their progressive disbursement. Instead of a lump sum upfront, funds are released in stages, known as “draws,” as specific construction milestones are met. This staged funding helps mitigate risk for the lender, as money is only disbursed for verified completed work, ensuring the project remains on track and within budget.

Types of Construction Loan Structures

Several structures exist for construction loans, accommodating land acquisition and home building differently. The most common type is the construction-to-permanent loan, often called a single-close loan. This option provides funds for both land purchase and construction, then automatically converts into a permanent mortgage upon project completion, often with a single closing. This streamlined approach means borrowers avoid two separate loan applications and closing processes, simplifying the financial transition to long-term homeownership.

Another structure is the construction-only loan, which covers only the costs of building the home. With this type, borrowers typically need to secure separate financing for the land or own it outright before applying. Once construction is complete, the borrower must pay off the construction-only loan, usually by obtaining a separate, permanent mortgage, which entails a second application and closing process. Owner-builder loans cater to individuals who manage their own construction project. These loans are often a variation of construction-to-permanent or construction-only loans, but lenders require the borrower to be a licensed builder due to increased risk.

Preparing for a Construction Loan Application

Securing a construction loan requires comprehensive preparation, including detailed documentation and financial readiness. Lenders assess a borrower’s qualifications, including financial stability and creditworthiness. A strong credit score, generally 680 or higher, is expected, though some conventional loans accept a minimum of 620, and FHA loans can go as low as 500 with a larger down payment. Lenders also review income verification through recent pay stubs, W-2 forms from the past two years, and bank statements, alongside a debt-to-income (DTI) ratio, which should be below 45% for conventional loans, though FHA allows up to 43% or, in some cases, 50%. Down payments vary, ranging from 10% to 25% of the total project cost, with government-backed loans like FHA requiring as little as 3.5%.

Detailed information about the land is also necessary. This includes:
An appraisal of the property
A survey
Clear title documentation to confirm ownership and identify any encumbrances
Verification of zoning compliance
Utility access (water, sewer, electricity)
Environmental assessments to ensure the land is suitable

Comprehensive details about the proposed construction project are needed, including:
Blueprints and architectural plans
A thorough construction budget with cost estimates for labor and materials
Clear specifications for all components
A realistic timeline for project completion

Information regarding the chosen builder is important, including:
Their licensing
Proof of insurance
A portfolio of past work
Professional references
A signed contract outlining the scope of work and payment schedule

Borrowers must demonstrate progress in obtaining all necessary building permits and approvals from local authorities, as these are prerequisites for loan disbursement.

The Construction Loan Application and Disbursement Process

Once preparatory documents and information are gathered, the next phase involves the procedural steps of the construction loan. The application package, containing all financial, land, project, and builder details, is submitted to the chosen lender. Following submission, the lender initiates the underwriting process, a thorough review that assesses the borrower’s financial stability and the overall feasibility of the construction project, including market conditions.

Upon successful underwriting and conditional approval, the loan moves to closing. During closing, funds for the land purchase are disbursed, if the land is part of the integrated loan, and the loan account is established. As construction progresses, funds are released through a series of staggered payments known as “draws.” This draw schedule is pre-determined and tied to specific construction milestones, such as the completion of the foundation, framing, or roofing. Before each draw is released, the lender orders an inspection by a third party to verify that the work has been completed satisfactorily and according to the approved plans.

The final draw occurs upon substantial completion of the project, after a final inspection confirms all work is finished and the property is ready for occupancy. For construction-to-permanent loans, this marks the transition where the short-term construction loan converts into a long-term permanent mortgage. This conversion occurs without an additional closing, simplifying the process for the borrower who then begins making principal and interest payments on the permanent loan.

Associated Costs and Financial Considerations

Beyond the principal amount of the construction loan, borrowers should anticipate other costs and financial considerations. Interest rates on construction loans are higher than those for traditional mortgages, ranging from 6.5% to 11.5%, reflecting increased risk for lenders due to the unfinished collateral during construction. During the construction phase, borrowers make interest-only payments on disbursed funds, with the principal balance growing as more draws are taken.

Closing costs for construction loans can be substantial and may exceed those of a standard mortgage due to complexity. These fees include:
Appraisal fees (which might involve multiple appraisals)
Inspection fees for each draw
Title insurance
Loan origination fees, which range from 1.5% to 2% of the loan amount

It is advisable to budget for a contingency fund, 10% to 20% of total construction costs, to cover unforeseen expenses or cost overruns. This financial cushion protects against unexpected material price increases, labor issues, or unforeseen site conditions.

Borrowers also account for ongoing expenses such as property taxes on the land and structure, and builder’s risk insurance, which protects the property during construction from perils like fire or vandalism. Other potential fees include re-inspection fees if work is not approved on the first attempt, or draw fees charged by the lender for processing each fund disbursement. These costs highlight the need for a detailed financial plan when embarking on a new home construction project.