Using Land as Collateral for a Construction Loan

While almost all home builders require a down payment to get started, Madison Homebuilders does not, with few exceptions. Madison Homebuilders builds your home on the strength of our company—so under average circumstances there is no need to even apply for a construction loan, saving thousands in construction loan interest. This post is a guide for those who are working with a home builder that requires a construction loan as part of their process and are thinking about using existing land equity to get a loan or line of credit to use as their down payment.

Using Land as Down Payment

If you own your own land and are considering building a home on it, you may have considered using any equity you have in the property (or the appraised value if you own the land outright) to help you pay for construction of the home itself.

Whether or not it is possible, or a sound financial decision, for you to use your land or land equity to establish a line of credit or take out an installment loan for the construction down payment depends on a few factors.

Before you begin:

  1. Check your credit score and get your land appraised before you begin so you have a basic understanding of your land’s value and the ballpark rate you can interest qualify for. Your lender may inspect the land to get their own estimated value, and if you’re approved they will quote a “loan to value” ratio, so expect to get a lower loan amount than your actual equity amount or land value.
  2. Remember that to qualify for this financing option, you will probably have to show proof of income like pay stubs or tax returns as well as credit reports to check your debt-to-income ratio. If you have an existing equity loan it can be especially difficult to qualify.
  3. Understand that it is usually more difficult to get approved for the use of land as collateral because land is more difficult for the bank to repossess and sell, and it is easier for the owner to walk away from. Raw land is relatively “ill liquid”, meaning it is hard to estimate the value as it cannot be sold quickly like a home or other “liquid asset”. If the land has been modified with grading, plumbing, or other building preparations it may be easier to assess value and secure an equity loan.
  4. Know that you may have to contact several lenders to find an experienced source for this type of financing. Since there are fewer of these loans available, you may end up paying a high interest rate or settling for a low loan-to-value ratio.

Next, let’s cover the differences between land equity installment loans and lines of credit.

Land Equity Line of Credit or Loan

If you are approved for a land equity loan or line of credit, you can use these funds for whatever you like, including a down payment for the construction of your home.

What is a land equity loan?

A land equity loan will allow you a lump sum to spend on your construction down payment with the option of a fixed or variable interest rate.

  • Type of disbursement: Lump sum
  • Interest rates: Fixed or variable
  • Loan amount: A land equity loan is a secured loan that is backed by your collateral (property), resulting in a higher borrowing amount and lower interest rate. Your loan amount will be lower than your actual equity or land value.
  • Repayment options: Choose from weekly, bi-weekly, semi-monthly and monthly installment payments. Your payments will be a combination of principal and interest.

What is a land equity line of credit?

Land equity loans can be compared to credit cards because they allow you to spend up to a certain credit limit each month. Just like a credit card, you have to make a minimum payment, and you have the option of paying off the entire sum at any time. You can continue to use your line of credit as long as you don’t’ spend more than your credit limit at any time. If your borrowing needs vary, and you want to make on-going purchases, a personal line of credit is probably a better fit.

  • Type of disbursement: A line of credit is reusable. Once you are approved for it, you can access any portion of the credit line at any time.
  • Interest rates: Variable
  • Line of credit amount: Depends on land equity and bank’s approved loan-to-value ratio. As with a secured loan, lines of credit secured by collateral typically result in a lower interest rate and higher credit limit.
  • Repayment Options: You pay interest on the amount you use, not the entire credit limit as you do with an installment loan. No matter how much you borrow, all of it plus interest must be repaid by the end of the term.

Risks of land equity loans and line of credits:

  1. Remember you will likely have to start repaying your loan or line of credit immediately. Factor this into your overall home building costs. Construction can sometimes be stalled or over budget, so make sure you can afford to make payments on your land equity loan and construction costs simultaneously.
  2. Understand that if you abandon the building process for whatever reason, or want to sell the home, you’ll still be paying the land equity loan.
  3. If you end up settling for a low loan-to-value ratio and are unable to repay the loan later, you stand to lose an asset of much greater value than the loan itself.
  4. Make sure you discuss this financing option with your home lender or homebuilder. They may want to see where you are getting your construction down payment from, and may have restrictions on using land equity.

How Madison Homebuilders Fits in to All of This

At Madison Homebuilders, we build your house on the strength of our company, so qualified landowners do not pay any construction costs until their home is complete. That means no interest payments. In addition, Madison Homebuilders agrees to pay your standard closing costs and the appraisal fee on your loan. All of this adds up to thousands of dollars in savings, as well as a simplified homebuilding process.

Interested in learning more about financing your custom home build in North or South Carolina? Start by downloading your free home plan book today!