Rebuilding when current house has a mortgage

The main complication is that you're destroying the collateral for a loan that you owe almost $200k on. Builders can do this because they're including their profit margin in the equity on the new loan. Since you're having a new house built, you would need to make sure that the construction cost plus the $185K you currently owe is sufficiently less than the market value of the house. If the value of the land alone is sufficiently high (meaning the cost of the actual house is much less than the resale value of the entire property) then it may be possible.

It may be cleaner to sell your house, using the equity that you've built up as a down payment on a newer, bigger house. Let the person that buys your house destroy its equity if they want.

I agree with D. Stanley's answer and started a comment that was getting a bit long.

One option here might be to get completely new loan that covers not only the construction but the remaining balance on the existing mortgage. At first this seemed unlikely to fly but it's not too different from getting a loan to buy a plot of undeveloped land and build a home on it. If the value of the land is more than $185K, I'm struggling to see what would prevent a bank from giving you the loan in the absence of any other reasons. By closing out the existing loan you eliminate complications around the collateral for that loan. It's also likely that the lender will want some guarantees on the new construction so you will need plans, permits, and a builder before you get the loan. When the old loan is closed out, that lender no longer has any interest in your existing home and the new loan will be associated with the new build and the land, not the existing building. Additionally, you can use a different lender for the new loan which opens up your options.

A couple of other thoughts: consider using the existing structure (such as the foundation) as part of the new home. Also, we have to assume you can afford this new mortgage which would be expected to be significantly more expensive but don't forget how it might change your tax situation. If your are doubling or tripling the value of the home, I would expect the property tax burden to likewise increase.

Building a house is expensive. It is not just the cost of building but also various fees for getting a permit, etc and in your case demolition of the old house and also possibly ground work if you do want to be limited by the foundations of your old house or they are no longer good. You should also not forget that building takes time and you will need a place to live during that time.

Considering this, it is highly unlikely that you will get this project financed. It also means that your new house will be a load more expensive than it seems as you pay off the 185k and the demolition cost as well.

For me it seems much more sensible to take some more money from the bank and let the renovations be done by a professional. Apart from not spending your evenings and weekends renovating, it will be done much faster when someone is working full time on it. This depends a bit on how much needs to be done