Construction loan for new house replacing existing mortgaged house?

Question

Let's say I buy a home with an ordinary thirty-year mortgage, intending to renovate the house slowly and live there a long time (ten years at least). Five years into the mortgage, however, I decide I want to build a new house, but I would like to stay at the same address. In other words, I want to have the old house demolished, and build a new house on the now-empty lot (while I live in a rental), then move back in to the new house and live there indefinitely.

The new house will be bigger and better than the old, so once it's done, the real estate as a whole (land plus improvements) will be worth much more than the original loan amount.

Is there a loan product that covers this kind of process? Can I take out a construction loan to finance the new building, and then roll it into a conventional mortgage, the way that people do who are building houses on raw undeveloped lots? What happens to my old mortgage when I do this?

I suspect that the lienholder may not want me to destroy the old house since that reduces the value of the property (at least temporarily) to the value of the raw land, but what other option is there? What do people do who want to buy an old house for the location, but intend from the start to tear it down and build a new house? Can this only be done with a large cash outlay upfront?

Answer 1

So let's assume some values to better explain this. For simplicity, all of these are in thousands:

• Lot value: $50
• Current house value: $200
• Current total market value: $250
• Current loan amount: $150
• Current equity: $100
• New house value: $300
• New total market value: $350
• New loan amount: $450
• New equity if no cash contributed: -$100! (that's negative equity)

So in this example, you're going to destroy $250 in value, pay off the existing $150 loan and have to invest $300 in to build the new house and this example doesn't have enough equity to cover it. You typically can't get a loan for much more than the (anticipated) property value.

Basically, you need to get a construction loan to cover paying off the existing loan plus whatever you want to spend to pay for the new house minus whatever you're planning to contribute from savings. This new loan will need to be for less than the new total market value. The only way this will work out this way is if you bring significant cash to closing, or you owe less than the lot value on the current property.

Note, that this is in effect a simplification. You can spend less building a house than it's worth when you're done with it, etc., but this is the basic way it would work - or NOT work in most cases.

Answer 2

Presumably the existing house has some value. If you demolish the existing house, you are destroying that value.

If the value of the new house is significantly more than the value of the old house, like if you're talking about replacing a small, run-down old house worth $50,000 with a big new mansion worth $10,000,000, then the value of the old house that is destroyed might just get lost in the rounding errors for all practical purposes.

But otherwise, I don't see how you would do this without bringing cash to the table basically equal to what you still owe on the old house.

Presumably the new house is worth more than the old, so the value of the property when you're done will be more than it was before. But will the value of the property be more than the old mortgage plus the new mortgage? Unless the old mortgage was almost paid off, or you bring a bunch of cash, the answer is almost certainly "no".

Note that from the lienholder's point of view, you are not "temporarily" reducing the value of the property. You are permanently reducing it. The bank that makes the new loan will have a lien on the new house. I don't know what the law says about this, but you would have to either, (a) deliberately destroy property that someone else has a lien on while giving them no compensation, or (b) give two banks a lien on the same property. I wouldn't think either option would be legal.

Normally when people tear down a building to put up a new building, it's because the value of the old building is so low as to be negligible compared to the value of the new building. Either the old building is run-down and getting it into decent shape would cost more than tearing it down and putting up a new building, or at least there is some benefit -- real or perceived -- to the new building that makes this worth it.