Getting a land loan is trickier than getting a mortgage
Reviewed by Julius MansaFact checked by Melody Kazel
A land loan is a type of credit that is used to finance the purchase of a plot of land. It’s sometimes called a lot loan.
You can take out a land loan if you’re interested in buying a piece of land to build a home. You can also use this type of loan to buy land to use for business purposes. The type of loan you take out, and how easy it is to qualify for, will depend on where you buy land and how you intend to use it.
Key Takeaways
- Getting a land loan creates a different set of challenges compared to applying for a mortgage on a house.
- For example, because lenders require surveyed boundaries, you’ll need to check zoning and land use restrictions on the property, as well as access to utilities and public roads.
- A build-ready lot will lower your borrowing cost compared with one that needs improvements.
- Other potential financing options include seller financing, local lenders, or a home equity loan.
- Rural land may qualify for a U.S. Department of Agriculture (USDA) subsidized loan.
What Is a Land Loan?
If you buy land rather than an existing house because you want to build from scratch, you’ll probably need a land loan. This type of loan can be used to finance your purchase of a lot of land, whether for residential or business purposes.
A land loan is a type of loan that is more complex than a standard mortgage. For one thing, there’s no home to act as collateral for the land loan. And normally, you can’t buy land with no money down. There are also several different types of land loan, designed to facilitate different uses for a land lot.
How Do Land Loans Work?
In general, a land loan works similarly to a standard mortgage. If you are approved for this type of loan, your lender will provide you with funds to buy your chosen lot of land. You will then pay them back, with interest, over the following years.
However, qualifying for a land loan can be more difficult than getting a regular mortgage because it is riskier for lenders. As a result, borrowers may have to prove that they have a good credit score (700 or above), and will have to explain what they intend to use the land for.
Borrowers should also highlight aspects of the property that need to be checked, like zoning, land use restrictions, surveyed boundaries, and access to utilities. These factors will give lenders an idea of how risky the loan might be.
Once all factors have been taken into consideration, the rates and other terms of the land loan can be issued. Land loan interest rates tend to be higher than standard mortgage interest rates, but a good credit score and low debt-to-income ratio can lower the cost.
Land Fundamentals
There are several up-front challenges regarding land, especially raw plots that are not clearly defined. To ensure that you’ll be able to utilize the land as you intend, research the following items and adjust your plans, if necessary.
Boundaries
First off, it is essential to be clear on what the potential purchase entails. It is vital to get the boundaries marked by surveyors and have everything on paper ready to be presented to the lender. Another important detail is to double-check zoning and land use restrictions.
Future Zoning
It is also wise to check with the local planning department to determine what the future holds for the immediate neighborhood. A new park down the street can raise property values in the coming years, while a new highway or sewage treatment plant is less likely to do so.
Access
For residential lots, access to utilities is a significant factor. Having water, sewer, electricity, and cable hookups ready to go saves a lot of time, money, and hassle. Similarly, public road access can be significant since the buyer will have to secure a permanent easement to access a public road if one is not already available.
Because buying land is different from purchasing a home, it’s a good idea to work with a real estate agent who specializes in land purchase transactions or construction loans.
Planned Use of Land
Lenders often do not like to take on too much risk. Buying land for development can be a risky endeavor. How you plan to use your land and when development will occur will affect how the lender assesses the risk of your loan. Some lenders may offer three- to five-year mini-perm loans to deal with the greater risk that they perceive.
Build Immediately
The terms of the loans—such as down payment and interest rate—typically hinge on the intended use of the land since this is directly linked to the bank’s risk exposure. In this way, getting land loans is always trickier than buying an existing house since a current house gives the bank immediate, tangible collateral.
However, developing land immediately often has less risk than developing it later because fewer variables may arise to prevent development in the future.
The Federal Deposit Insurance Corp. (FDIC) has established lending policies for institutions regarding the loan-to-value limitations for land. All loan terms are up to each lender’s internal limits but should not exceed FDIC guidelines. Construction of a one- to four-family residence calls for a 15% down payment (or 85% loan-to-value limit).
Improvements Needed
Some land may not be ready to be developed. This might have been known at the time of purchase or only discovered later. Bear in mind that there is more risk involved with land that needs improvements as additional uncertainties may cause escalating prices or further complications related to development. The FDIC loan-to-value limit is 75% for land development, often requiring a deposit of up to 25%.
Speculative Investment
Finally, there is raw land with no specific plans for any development. This would be considered a speculative investment.
For example, this could involve buying land in anticipation of the completion of a new freeway nearby. The hope would be that when the freeway is completed, the land would be attractive to a developer who wants to build a new subdivision with a convenient commute into the city. The land could then be sold to the developer for a tidy profit. Although the FDIC loan-to-value limit is 65%, lenders may feel compelled to require down payments greater than 35%.
Important
Unimproved lots are ones that do not have basic required services such as water lines, electricity lines, or access to public roads. With such lots, it is common to run into unforeseen problems and cost overruns, which can add months to the purchase time line.
Other Land Loan Financing Options
Given the above challenges, you may want or need to search further to find more acceptable terms to finance your land purchase. Here are a few resources that you can investigate.
Seller Financing
This can be a good option for getting favorable terms, especially if the seller is eager to unload the land and the market is cool. Since this is an agreement between two private citizens, everything is negotiable, from the down payment to the interest rate. It is important to have the papers reviewed by an attorney before signing anything. That way, both parties can avoid loopholes and unpleasant surprises.
Local Banks and Credit Unions
Local banks and credit unions typically look more favorably on land loans than larger banks. They also may offer better terms due to their local knowledge of the property and their community relationship. All the same, a potential borrower will need to present a loan package with specs and plans for the land as well as personal financial information to prove creditworthiness.
USDA Loan
How can buyers purchase land if the banks and credit unions do not offer financing? If the property is rural and agricultural, the buyer could obtain federal aid. The U.S. Department of Agriculture (USDA) offers an assortment of subsidized loans with minimal requirements and advantageous terms.
Home Equity Loan
A buyer with existing property and little debt may want to consider a home equity loan. This type of loan taps the equity of the existing property, granting much better terms than any regular construction or land loan.
Pros
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Land loans can be useful to small businesses connected to land.
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Government programs like USDA loans may provide land buyers with affordable interest rates and very little or no money down.
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Ready-to-build lots may be less expensive in some areas than new homes.
Cons
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Not all lenders offer land loans.
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A survey and review of the zoning rules are needed when approaching a loan officer for a land loan.
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Some land loans have short repayment periods.
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If you use your primary residence as collateral on a land loan and default, you could lose your home.
Is It Difficult To Get a Land Loan?
Getting a land loan is more difficult than obtaining a traditional mortgage because buying land isn’t as straightforward as buying a home. Many banks and credit unions do not easily offer land loans. So you have to be very specific about the land you are going to purchase and be prepared to provide surveys and zoning information.
Is Owning Land a Good Investment?
Owning land can be a good investment depending on the land, its location, and how you plan to use it. For example, a plot of ready-to-build land for a primary or secondary home has a different degree of risk than a piece of raw land intended for farming.
What Is the First Step To Applying for a Land Loan?
The first step to applying for a land loan may be locating the right lender for your purchase. Not all lenders offer land loans, but plenty are out there. A local credit union might be a good fit if you are going to work to develop land in your community. You will need to gather all of the paperwork, including a land survey, and information on how you plan to use the land.
How Do You Finance a Land Purchase?
There are several options. One is a land loan. However, you may also qualify for seller financing, local lenders, or a home equity loan. It’s worth exploring each option before you commit to a loan.
The Bottom Line
Financing a property on which to build your dream home is much more complex than applying for a mortgage. Lenders require surveyed boundaries, and you’ll need to check the zoning and land use restrictions, as well as access to utilities and public roads. The more improved the land, the lower your required down payment and borrowing costs will be.
The best options to finance a land purchase include seller financing, local lenders, or a home equity loan. If you are buying a rural property, be sure to find out if you qualify for a USDA subsidized loan.
Read the original article on Investopedia.