Land Loans vs. Construction Loans: Understanding the Differences and Which to Choose
In the simplest terms, a land loan is like a mortgage for the specific purpose of purchasing land. A construction loan finances the cost of construction but becomes a more traditional mortgage after the house is built. In most respects, they’re similar to traditional mortgages a homebuyer might apply for if they were simply purchasing an existing home.
New construction loans through OnPath Federal Credit Union are exceptionally flexible in that you don’t need separate loans for purchasing land and constructing a home. A land loan can essentially be rolled into your new construction loan to simplify the application process and monthly payments.
Land Loans
A land loan (specifically a residential land loan) is a type of loan that you can take out to purchase a plot of land on which you plan to build a home. The land could be empty, undeveloped or it could already have some improvements. The attractiveness of a land loan is that it allows you to secure a piece of property before you start building.
Land loans typically have higher interest rates and require a larger down payment (often 20 to 50 percent of the land's value) compared to traditional home mortgages. This is primarily because lenders view land loans as riskier. If a borrower defaults on the loan, it's generally harder for the lender to resell an empty plot of land than a home.
New Construction Loans
A new construction loan is a short-term loan used to cover the cost of building a new home or undertaking a significant home renovation project. At OnPath FCU, we can include the funding for purchasing the land in the new construction loan.
Construction loans are a bit different from traditional mortgages in that the lender doesn't disburse the entire amount upfront. Instead, the borrower gets 'draws' or partial disbursements as different stages of the construction project are completed.
A construction loan is typically interest-only during the building period and then it must be paid off or converted into a traditional mortgage once the construction is finished.
At the start of the loan the risk borne by the lender is similar to that of a land loan. If you don’t build the home and default on your loan, the lender stands to lose a lot of money. However, terms may change once the home is constructed and you convert it into a more traditional mortgage.
Transitioning from a Construction Loan to a Mortgage
The terms of a construction loan typically change when it transitions into a traditional mortgage, commonly referred to as the "permanent loan" or "end loan." This often means going to a traditional fixed-rate mortgage with a standard term and making regular payments on both interest and principal each month (instead of just interest payments on a short-term variable rate construction loan).
Should You Apply for a Land Loan, Construction Loan or Both?
When should you opt for a land loan or a construction loan? The answer depends on your circumstances and future plans. With some lenders you might need to do both loans separately, but OnPath FCU enables members to obtain both with one loan and a single application process.
If you've found a plot of land that you love but you're not ready to build, a land loan could be the right choice. It allows you to secure the land and gives you time to plan your construction.
In contrast, if you own land already or know the plot of land you want to buy and are ready to start building, a construction loan is what you need. It helps cover the costs of building your dream home and is typically converted into a standard mortgage once construction ends. This way, you only have to go through the loan process and pay closing costs once.
The answer to the question of which loan is right for you is largely situational. If you’re not ready to start construction, you should strongly consider a land loan. If you’re ready to start building in the near term, you should look into a construction loan.
It's always a good idea to speak with a trusted financial advisor or loan originator to help you navigate these decisions. The mortgage experts at OnPath Federal Credit Union are always happy to help and can explain the features of our new construction and land loans. Speak with a member of our team by calling 504.648.2064.