Coming up with financing with which to build a new home on vacant land has some things in common with financing an existing home – but some significant differences, too, which may affect your ability to qualify for the loan you want. When you finance an existing home, the bank doesn't have to worry about whether the structure will get built. When you finance new construction, the collateral doesn't exist yet, so the bank will look all the more carefully to your ability to pay for a project in which even the best management may mean increased costs.
The estimated cost of building the house that you've designed and engineered is the point of departure for establishing the amount of the construction loan. Your architect or builder’s construction plans and other documents will determine the estimated cost of building your new house.
In addition to the costs of construction, the bank will insist on reserves: a contingency reserve (usually 5% to 10% of the estimated construction costs) and an interest reserve (if you don’t want to pay the monthly interest payments on the construction loan out of pocket). Both you and the bank want to be confident that there are sufficient funds available to finish the project if there are cost overruns or if the unforeseen happens, like a builder’s bankruptcy.
If the project comes in on budget, you won’t need to draw down the reserves. On the other hand, cost overruns that exceed the contingency reserve will be your responsibility.
When you apply for a conventional mortgage loan to purchase an existing home, the bank looks to your financial strength and to the value of the existing home for assurances that you’ll repay the loan. With new construction financing, the bank will look more carefully at your financial depth, because the collateral for its loan doesn't exist yet. Thus, for new construction, the bank’s credit, income, and repayment requirements will be more stringent.
To prove your creditworthiness, the bank will obtain (and you will pay for) copies of your credit score and history. You will need to provide evidence of your income (tax returns, W-2 statements, and the like) that meets the bank’s required income-to-loan ratio (all of your prospective monthly debt payments, including your new mortgage, insurance, and real estate taxes, divided by your monthly pre-tax income.) The required income-to-loan ratio is typically 35% to 45%. Basically, it measures how much of your income will be committed to paying for housing. The lower the ratio, the smaller the impact of your new debt obligations on your household budget and the more confident the bank can be that you’ll be able to repay the loan.
A lower income-to-loan ratio should also get you a lower interest rate on your loan.
The bank or lender that provides your construction financing will probably provide your permanent financing, as well. If it doesn't, you’ll additionally need to demonstrate how you will repay the construction loan, for example, with permanent financing from another lender.
The bank will expect you to own (or at least control) the land you want to build on. If you own it outright, you’re that much stronger financially in the bank’s eyes. If you need to pay off an existing land loan or purchase land that is under a purchase and sale agreement, the bank will fold the pay off amount or the purchase amount into the construction loan, but – because the land by itself isn’t excellent collateral – it will increase its other credit requirements.
On the other hand, if you already own a house and you've been able to build up substantial equity in it, you’ll be more likely to qualify for a larger loan amount and/or a lower interest rate.