What property buyers should know about land loans

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If you’re eyeing a piece of land to build a house on or to use for business purposes, don’t expect a traditional mortgage lender to finance the purchase. You’ll probably have to apply for a land loan.

Land loans aren’t as common as mortgage loans, so there are fewer options. And you could face with a bigger down payment requirement, a higher interest rate and less time to repay the loan than you would with a mortgage.

If you apply for a land loan, it’s important to know what you’re getting into and how to reduce your costs.

What are land loans?

A land loan is used to finance the purchase of a tract of land. Land loans are a very small slice of the market and tend to be riskier for lenders than mortgage loans, says Casey Fleming, a mortgage adviser with C2 Financial Corp. in San Jose, California.

If a lender has to foreclose on a land loan, there’s no guarantee of recovering the money. “Owners of raw land are much more likely to stop making payments and walk away from the property in the event of a financial event in their lives,” Fleming says.

“If you own your own home, you’ll do anything you can to save it. With raw land, you can’t use it or generate any income off it.”

Vacant land is much harder to sell than a lot with a house on it because there is less demand for land than there is for new and existing homes. “Most people can’t handle buying land and building something on it,” says Fleming. “It involves a lot more time and money than people expect. Even if it’s a fixer-upper, people want something they can start with and work from there.”

When you consider these realities, it’s easy to see why a land loan is likely to have less-favorable terms than a mortgage loan. Some lenders require a substantial down payment and charge higher interest rates on land loans. Also, some land loans have significantly shorter repayment terms than a typical 15-year term or 30-year term mortgage.

5 types of land loans to finance your land purchase

There are five common types of land loans you can get to finance your land purchase, each with its own terms and features.

  1. Lender land loans

Community banks and credit unions are more likely to offer land loans than large national banks. Your best bet is to find a lender with a presence near the land you want to buy. Local financial institutions know the area and can better assess the value of the land and its potential.

If you don’t plan to develop the land, interest costs will be steep, Fleming says. Plus, a lender could require a down payment as high as 50 percent.

However, some lenders may be willing to collect a lower down payment and charge lower interest rates if you have plans to build on the land soon. Local lenders are more likely to offer longer repayment terms, giving you more time to pay the debt.

As you would with any loan, shop around before you apply.

  1. USDA Rural Housing Site loans

If you’re planning to build a primary residence in a rural area, the U.S. Department of Agriculture (USDA) has a couple of loans that can help.

Section 523 loans are designed for borrowers who plan to build their own home, while Section 524 loans allow you to hire a contractor to build a home for you.

Both loans are designed for low- to moderate-income families and have a repayment term of just two years. Interest rates, however, can be low. Section 523 loans, for instance, charge just 3 percent, while Section 524 loans charge the current market rate.

Depending on the situation, you may even qualify for a loan with no down payment.

  1. SBA 504 loans

If you’re a business owner planning to use the land for your business, you may qualify for a 504 loan through the U.S. Small Business Administration (SBA).

With a 504 loan, you, the SBA and a lender help contribute to the costs of the land purchase:

  • The SBA provides a loan for 40 percent of the purchase cost.
  • A lender provides a loan for 50 percent of the purchase cost.
  • You contribute 10 percent in the form of a down payment.

SBA loans come with a 10- or 20-year repayment period, and the interest rate will be based on current market rates. The terms of the loan you receive through the lender can vary, however, depending on which lender you choose.

  1. Home equity loan

If you have an existing home with significant equity, it may be worth getting a home equity loan instead of a land loan.

There’s no down payment on a home equity loan and you can typically get a low interest rate, regardless of what you plan to do with the land, because your home secures the loan.

The downside is that if you default on the loan, you could lose your home. Also, since you’re not using the loan to buy, build or substantially improve the home used as collateral, the interest you pay is not tax-deductible.

Depending on the lender and the loan, your repayment term could be between five years and 30 years.

  1. Seller financing

In some cases, the person or company selling the land may be willing to offer short-term financing. However, the typical seller isn’t in the lending business and doesn’t have a broad portfolio of loans like a community bank or credit union.

As a result, you can expect high interest rates and a hefty down payment. Also, it’s unlikely you’ll get a long repayment term. Consider this option only if you can’t qualify for any other type of land loan.

How to find the right land loan for you

There’s no single best land loan out there for everyone, so it’s important to shop around to find the best one for your situation. Before you do anything, Fleming recommends developing a comprehensive plan for what you want to do with the land.

Doing this can help you determine what type of loan is best and how long you want the repayment term to be.

Keep in mind, though, that some lenders may have limits on how much they’re willing to finance. Others may require a balloon payment, which is a large, one-time payment at the end of the loan term. “You may have to have a plan to pay it off before that payment comes due,” Fleming says.

As you consider your loan options, make sure you choose one that fits within your budget and helps you achieve your ultimate goal with the land.

Taking out a land loan to buy and build from scratch isn’t for everyone, says Fleming. “But those who do are usually pretty satisfied when their project is finished.”