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, you probably won’t be able to get a regular mortgage to finance the purchase. Instead, you’ll likely have to settle for a land lease or apply for a land loan if you want to own the land outright.
Land loans aren’t as common as traditional mortgage loans, though, so there are fewer options. With less competition between lenders, you could face a bigger down payment requirement, a higher interest rate and less time to repay the loan than you would with a traditional 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 is a land loan?
A land loan is used to finance the purchase of a tract of land. There are a few different types of land loans depending on the type of property you want to buy:
- Raw land: This type of land typically doesn’t have access to utilities and has no improvements; it may not even be accessible by road. Raw land is generally more inexpensive than the alternatives, but it can be difficult to get financing.
- Unimproved land: An upgrade to raw land, unimproved land (aka undeveloped land) may have access to some utilities but still lack others, such as a phone line or a meter for gas or electricity. Obtaining financing for unimproved land is easier than for raw land, but can still be challenging.
- Improved land: Many buyers prefer improved land because it is developed with full utility and road access. While it’s the most expensive type of land, it’s the easiest to finance.
Land loans are a very small slice of the lending market and tend to be riskier for lenders than mortgage loans, says Casey Fleming, a mortgage advisor at Silicon Valley Mortgage and author of The Loan Guide: How to Get the Best Possible Mortgage. 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 already-constructed homes.
“Most people can’t handle buying land and building something on it,” Fleming says. “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.”
While there are fewer institutions that extend land loans than other types of home financing, it’s still a good idea to shop around if you can to make sure you’re getting the best possible terms.
How do land loans work?
Some land loan lenders require a substantial down payment — ranging from 20 percent to 50 percent of the purchase price — and charge higher interest rates. Others have significantly shorter repayment terms than a 15- or 30-year mortgage, as well, or specific requirements, like a cap on the amount of acreage. Credit reporting agency Experian advises that people who are seeking a land loan should anticipate needing a credit score in the high 600s to the low 700s at a minimum, as well as a debt-to-income ratio of no higher than 43 percent. You may not get approved at all unless you submit a detailed plan for what you want to do with the land. As of late 2022, you can probably expect an interest rate of 7 percent or higher.
The process of applying for a land loan and receiving the funds, however, is somewhat similar to that of a typical mortgage. The lender will run a credit check and evaluate the financial documentation you provide to ensure it matches what’s on the application. You may have luck getting a USDA land loan if you plan to build on rural land. If you plan to build yourself, you can use a Section 523 loan. If you’re hiring a contractor, you will apply for a Section 524 loan.
If you’re approved, the lender will disburse the loan proceeds to the seller and you’ll repay the lender with interest over a predetermined period of time. Some land loans are structured as balloon mortgages, with interest-only or no payments for a set time, then the balance coming due in one large payment.
“You may have to have a plan to pay it off before that payment comes due,” Fleming says.
As for how much you can borrow for a land loan, your approval will depend on factors like the type of land you’re buying and your lender’s preferences. One lender might help you finance up to 85 percent of the cost of developed land, for example, or 70 percent of the cost of raw land. Keep in mind that how much you can borrow is also related to your creditworthiness, how much cash you have on hand, and your down payment amount.
Land loan rates
Because land loans carry more risk, lenders tend to charge higher interest rates. Experian puts the current rates at about 7 percent. FBN Finance, a major player in the field, is quoting just over 7.5 percent for its 30-year Farm Land Loans. The rate you’ll receive is also tied to your down payment amount and creditworthiness. Because these loans tend to be more expensive, it’s all the more important to take your time to compare multiple lenders before you settle on one.
Types of loans for land purchase
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 usually 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, and a lender could require a down payment as high as 50 percent.
As you would with any loan, shop around before you apply.
2. 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 two loan options to consider:
- Section 523 loans are designed for borrowers who plan to build their own home.
- 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. The interest rates, however, can be low. Section 523 loans, for instance, charge just 3 percent, while Section 524 loans charge less than the current market rate, with the rate on your specific loan fixed at closing.
3. 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.
The interest rate on a 504 loan is based on current market rates. The other terms of the loan can vary by lender, however.
4. Home equity loans
If you already have a home with significant equity, it might be worth getting a home equity loan instead of a land loan. There’s no down payment required on a home equity loan, and you can typically get a low interest rate since it’s secured by your home. Loan terms range from five years to 30 years.
The big 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 mortgage interest you’ll pay is not tax-deductible.
5. Seller financing
In some cases, the person or company selling the land might be willing to offer owner or 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. So 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.
Pros and cons of land loans
Land loans are used in pretty specific circumstances, so they’re not useful for a huge share of homebuyers. Here are some ways they might make sense for you and some ways they won’t:
- Simple way to finance a project if you’re buying an empty lot and building a new home for yourself
- Government programs may help you get low interest rates with a small or no down payment requirement
- Can help small business owners get established in a new location
- May be difficult to find a lender
- May be charged a high interest rate or need to tap your home equity if you don’t qualify for a government program, which could jeopardize your current property
- Could have a short repayment period, which means high monthly payments until the debt is paid off
Taking out a land loan to buy and build from scratch isn’t for everyone, Fleming says. “But those who do are usually pretty satisfied when their project is finished.”
How to get a loan to buy land
1. Develop a plan. Before you start looking for a loan, Fleming recommends developing a comprehensive plan for what you want to do with the land. That can help you determine what type of loan and terms are best for your goals. Having a written plan may also increase your chances of getting approved for a loan later — many lenders won’t approve a loan if you don’t explain what you intend to do with it.
2. Search for properties. If you haven’t found a site yet, use websites like LandWatch, LandSearch and Land.com to search for properties based on your preferences and what you plan to do with the land. You can also use these online platforms to connect with a real estate agent who specializes in land purchases.f
3. Check your credit score. It’s hard enough to get a land loan as it is, so you don’t want to do yourself a disservice by applying with a low credit score. Check your score now and make a plan for getting to 700 if you’re not there already. This might require paying off credit cards or waiting several months for a past late payment to finally fall off your report.
4. Shop around for the right lender. As with any other type of loan, it’s important to shop around. It can be a good idea to work with a broker experienced in land loans. If you want to shop around yourself, start by determining if you qualify for any of the government-sponsored loan programs. It’s also worthwhile to get in touch with local lenders and credit unions as they may be more likely to extend you this kind of financing.
A quick online search for land loan providers in your area may also help you secure financing for a land purchase. Make sure you read the requirements carefully and reach out to a loan officer to talk about your situation and your chances of getting approved.
If you already have a land loan secured and didn’t get it through the SBA or USDA programs, your next step is to connect with a construction loan lender. Check out Bankrate’s guides to home construction loans and some of the best construction loan lenders to learn more.