If you’ve ever felt the disappointment of finding a great lot in the perfect community, but the house sitting on it is sadly outdated, too small, or simply not your style, you’re certainly not alone. For many first-time and repeat homebuyers, location is a significant factor in purchasing a home. If you have your heart set on a particular lot, you might consider whether a tear down option is right for you.
For many homeowners, choosing the ideal location that fits their current and future needs is worth the process of purchasing a house (and land), tearing down the structure, and rebuilding an energy-efficient or updated model. It can save utility and repair costs in the long run, depending on the age of the structure and its current level of functionality. If the home is not structurally-sound, built for safety in hazardous weather conditions, or is dilapidated, it may be difficult for the seller to get it off the market at any price.
If you decide to purchase a tear down home, you will want to consider the financial aspects. Financing a tear down house is a bit more complicated than a standard mortgage, as the process involves destroying your mortgage collateral by demolishing the house.
Lenders want to be assured that in the case of default, they can foreclose on your home and maintain their assets. If you demolish your home, they have little or nothing to take back if the new home is not completed. Not to mention in many cases, if you make changes to your home that decrease its value, it can become a legal issue with your mortgage lender. It’s best to be honest and upfront with your lender, who can advise you of your options for financing your rebuild project.
I’ve put together a short checklist of financial considerations to keep in mind when you decide to purchase a tear down and rebuild. This includes ideas and options for financing the purchase of the tear down home, its demolition, and the costs for new construction. Of course, you should also consult a loan expert before making any big decisions.
Before You Buy: A Checklist
Before you make any moves on purchasing property, be sure to take these initial steps.
Check Your Credit Score
This is the report card for life. Checking your credit report prior to making any plans or construction meetings will save you an immense amount of time, money, and stress. Being aware of your credit will help you to determine which loan products you may be eligible for and what options are available. You certainly wouldn’t want to pay someone to draw up new home designs before you learn that your credit makes you loan-ineligible.
Count Your Savings
No matter which loan option you choose, you can expect upfront costs and out-of-pocket expenses. Be sure that you have enough cash on hand to cover any additional costs, such as bank fees, loan fees, home design plans, and anything else that is needed prior to meeting with the lender.
Pay Outstanding Loan Amounts
It may be the case that the tear down home is owned by yourself or a family member and has an outstanding mortgage balance. In most cases, you will not be able to demolish a home for which a balance is owed. Ensure that you own the home outright by paying the remaining balance in full, if required.
In a few cases, if the outstanding balance is minimal, you may be able to obtain written permission from your lender to roll the balance owed into your new mortgage. But keep in mind that lenders will not grant permission if your balance is more than the value of the land, which will be the sole equity after the home is destroyed.
Consider Your Options: Total Tear Down or Substantial Renovations
It’s a good idea to have a construction expert visit the site to determine how much work will be required. Some homes may require complete demolition while others can get away with substantial renovations. Some counties and areas have existing codes and regulations about tear downs that could complicate the process and lengthen your timeline. Other areas may encourage substantial renovations with special loan products and tax incentives.
Purchasing a Tear Down Home
As previously noted, purchasing a home for the purpose of tearing it down is tricky. You may be able to negotiate with your lenders using other collateral, such as your current house or lump sum savings. A combination of equity and cash may be a practical solution.
It’s also possible to use income from the sale of your previous home and make the purchase of the tear down house contingent upon that sale. The seller may or may not agree to this, but it’s worth a try.
Depending on size of the house, location, and required disposal methods of certain toxic materials such as asbestos, your house demolition may cost between $5,000 and $20,000. Before you call in the bulldozer, first check with local authorities to determine if there are any required inspections or oversight that should be completed. Additionally, you may need to pay to obtain permits and secure the site during the demolition.
However, if you don’t plan to save various pieces of the house and recoup some of the cost, there are a few ways to dispose of the house for free. You can donate the home – someone may actually want it! If they are willing to pay relocation costs, hire a professional company to raise the house onto a flatbed truck and drive it to a new location, that’s an easy fix. Or, you could donate the home to a local fire department to set a controlled fire. This can be an ideal training tool for firefighters who need to learn how to properly extinguish a blaze.
Loan Option #1: Construction-to-Permanent
The first step for financing is to contact your local trusted lenders to learn what types of loans are offered for reconstruction and renovation costs. Not all lenders offer the same products, but you will find the three most common outlined below.
The Construction-to-permanent loans are the most popular for this type of project. Tear down home buyers utilize a construction loan to cover the expenses of demolition and rebuilding. At the end of the project, the loan will convert to a permanent mortgage. These may be called “one-time close” loans due to their elimination of the separate closings for construction and mortgage, thus saving the buyer thousands in closing costs.
As a general rule of thumb, a tear down and rebuild project should result in a new home of at least two or three times the value of the original teardown. Lenders will consider whether the value of the projected finished home will be adequate to support the total of your new permanent mortgage. If you default on your loan, the lender is still able to recoup the outstanding balance by selling your property.
Loan Option #2: Construction-Only
A construction-only loan is a short-term loan that only covers the cost of new construction. There is no option to combine this type of loan with your mortgage payments and it must be paid entirely when the building is complete, typically by a traditional mortgage. As with all mortgages, credit score eligibility, debt-to-income ratios, and required down payments vary by lender.
With any construction loans, it is typical for lenders to require oversight and approval of all building plans, site measurements, financial documentation, and partner with preferred design/build firms.
Loan Option #3: Renovation-Construction
A renovation-construction loan covers the expense of major (or minor) renovations to a home. It may be combined with the purchase price to make one single loan. If you choose to purchase a fixer-upper and make substantial renovations rather than demolish it, a renovation-construction loan may be the best fit.
The FHA 203(k) and HomeStyle loans may be used for major structural repairs and/or cosmetic renovations. You have the option to add up to six months of mortgage payments to the loan if you are unable to occupy the structure during the renovations. Funds are placed in an escrow account and contractors are paid in draws as they complete project milestones.
203(k) Standard Loan
An FHA 203(k) Standard loan is available for borrowers with a minimum 500 credit score. The required down payment decreases with a higher credit score. These loans cannot be used for anything that FHA deems as a luxury. Thus, you can’t install a Jacuzzi or fancy outdoor sound system with the funds. A 203(k) loan is strictly for a primary residence and cannot be used for a vacation home. You may use a 203(k) loan to tear down and rebuild a home, as long as the foundation remains intact.
Fannie Mae HomeStyle loans are available to borrowers with a minimum 620 credit score and require a low down payment. HomeStyle loans will only work for homes with substantial renovations; tear down homes are not eligible. They can be used for second homes or investment property and have fewer restrictions on allowed renovations.
Build Your Dream Home
Starting with a bit of research, you can get a basic idea of how much a tear down and rebuild may cost and how much you have in your budget. Once you have a preliminary outline, it’s a good idea to commit to a builder that you trust who can advise you on the specifications of cost and timeline. When you’re ready, set up a call with your lender and/or a loan consultant to go over any questions and ensure that everyone is on the same page.
Melanie Theriault is a writer, counselor, and lifelong learner. She holds a B.A. in Sociology from Southwestern University, where she discovered her passion for fostering human connection through storytelling.