Unless you’re in a very lucky position, chances are you’ll need to take out a loan to build a new home. What you may not be aware of is that you can use your vacant lot as equity for a construction loan. But how does this work, how much equity can you get and is it even a good idea? Let’s take a look at using land equity construction loans including the pros and cons and how the process works.
How can I use the land as equity for a construction loan?
First thing first, let’s define exactly what land equity is as it’s vital to understand this for the rest of the article to make sense. Land equity is the difference between the amount your land is worth and how much you owe on it. Another way to think of it is, if you were to sell your block of land tomorrow, the amount of money you have left after covering your debts is your land equity. If you own the land outright, then you are in the envious position of having 100% equity.
In terms of using land as collateral in your loan application, land equity is the magic number that will determine how much a lender is willing to give you (otherwise known as your borrowing power).
When it comes to market value, the land is usually worth more than the actually house itself. This is especially true in areas that have met the potential growth they had a decade or so ago. Land values go up and down over time, so if you’ve owned your block of land for a while, you’ll need to get an updated valuation. Who knows, your land might be worth more than you realised.
Important note: using land as equity is different from getting a loan to buy land.
If you’re looking to purchase a block of land, you’ll need to apply for a vacant land loan. This is a completely different process which we will cover in a future article.
Weighing up the pros and cons of using land as equity
Every decision you make concerning borrowing money will have its pros and cons. Using land as equity is no exception to this and here are some advantages and disadvantages of taking this step.
- It’s a quicker way to get loan approval and get started building your home.
- Can be convenient
- Makes the most of your land purchase
- Though no investment is risk-free, land is a valuable commodity that often rises in value. This is great news in terms of equity.
- Some people find it more manageable to have money lent in stages
- Can come with higher interest rates
- Land equity can vary wildly from block to block.
- Despite the impression one gets from the news, land value can drop. This could mean your land equity won’t be as big a leg up as you were expecting.
How much can you borrow for a construction loan when using land as collateral?
The answer to this will come down to a number of factors, including the type of loan you’re after, the value of your land, any other debts you may have, your income and the lender you’re dealing with.
In cases where you are in a strong financial position (good credit history, reliable income, money for the deposit), you can get as much as 80% of the equity of the land loaned to you as a construction loan.
What makes the land more valuable?
The more valuable your land is the higher the equity loan you’ll likely be able to borrow. If you’re trying to estimate your current land’s value or are purchasing land in the future, here are some of the key factors that will influence your land valuation:
- Location of the land
- Size of the block
- Future developments in the area: These could be developments that raise value like a school or something that doesn’t like a highway.
What documentation do I need to provide lenders if I want to use land as collateral?
The key piece of information you’ll need is an accredited valuation figure on the land. If you haven’t got one, you’ll need to sort this out in your own time with your own money. However, even if you do have a valuation, your lender won’t necessarily accept it and ask you to get another one. Some of the key reasons for this are:
- The original valuation was taken too long ago
- Your lender wants to ensure the price you’re quoting is accurate.
How does a land equity construction loan work?
Construction loans work by having the lender provide money in stages throughout the building project. While you’ll likely need to provide a percentage of the total purchase value as a deposit (often around 20%), a land equity loan can go a long way to covering your costs. If you cannot cover the deposit you may be required to purchase Lenders Mortgage Insurance (LMI) which helps cover the lender if you can’t pay back any of the amount.
Remember, your land isn’t the only factor your lender will take into account when deciding on your loan amount. Other things such as your and your partner’s credit history, bank balance, other equity and income will all be considered when you make an application. For example, if you’re in serious debt, it could negate a lot of the benefits of your land equity.
Is using land as equity on a home loan a good idea?
It depends on your situation. In an ideal world, you wouldn’t need to get a loan at all, but we’d all love to have a bank balance in that sort of shape. Using equity to help with a loan is a common tactic and can allow you to borrow much more than you otherwise could. Construction loans themselves come with their own pros and cons, so read our guide to find out whether this is the right choice for you.
As with any loan, the crucial detail you need to consider is whether you can pay it back. Talk to a financial advisor to weigh up your options. We understand financial planning can be stressful and at times disheartening, but having a firm understanding of your budget can make all the difference in a project as big as building a house.