How to Use Land as Collateral for a Home Loan Downpayment

How to Use Land as Collateral for a Home Loan Downpayment
How to Use Land as Collateral for a Home Loan Downpayment | monkeybusinessimages/iStock/GettyImages

Land value, or equity in land, can be used as the equivalent of cash for a down payment when building a home. To know if you have enough equity in your land to build a home with little or no additional out of pocket cost, generate a list of potential building expenses and closing costs. Then, get an appraisal on the value of your land and present this information to your home loan officer. They will then tell you whether or not you are able to use your land as collateral for a home loan downpayment. Here are tips to navigate through this complex process.

Schedule an appointment with a lender. You should choose a company that specializes in new construction lending for your prequalification. The first meeting will be to discuss your construction plans, credit history, the types of loans available and what kind of loan you can really afford. The lender can provide you with the costs involved to close a Construction to Perm loan, giving credit for your land equity. If a previous appraisal has been conducted already, you can submit it once you choose a lender. However, there will likely need to be a more recent one completed for the purposes of this loan.

Contract with a reputable builder. To start, schedule a time for him to view the land and discuss your plans. A reputable building contractor will need to see the land before they can tell you what is and is not possible. Once you have gone over what you are looking for in detail, have him draw you up a cost estimate on what it will take to build your home.

Calculate total building and closing costs. Add this amount to the value of the land. The grand total represents the cost to produce your project. The value of the land is then used as a credit against the total cost. If you owe a balance on the land, total all of the costs and add the balance of the land payoff. Depending on the bank's percentage for the construction loan, you may still have to come up with some form of a monetary down payment.

View an example to be sure you understand the process. Let's say your cost to build is $220,000 and the land is valued at $63,000. You may have closing costs that total $15,000, depending on your state taxes and costs, so the total value of the cost to produce this project is $298,000. When you subtract the credit for the land, your new loan will be $235,000, and this is just about 80% of the cost to produce the project. You would not incur private mortgage insurance on a conventional loan, and no substantial costs to pay. There are formulas that are used by various lenders to compute loan percentages, some allow for a 5% variance in "holdback" just in case material costs increase or to account for unknown variable; however, this is the basic formula for how this process works. If there is still a lien on the land, you can still use the equity as a credit, and the balance will be paid off when you close your construction loan.

Make a final decision based on what you can afford. If the bank will only loan 90% of the costs, and the equity in the land represents less than 10%, you will have to generate additional funds. Example: $220,000 cost to build, land value $63,000, closing cost add up to $15,000, but you owe $47,000,000 on the land. The cost to produce the project is still $298,000, but your land credit is now $16,000. ($63,000 minus $47,000). The 10% represents $29,800 required down payment, so the difference would be $13,800 of out of pocket cost to you. Only you know what you can truly afford, but remember, once the building process has begun, it is very difficult to back out. So be sure you make an informed, sound decision before hiring a contractor to build your dream home. .