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; you’ll likely have to apply for a land loan instead.

Land loans aren’t as common as mortgage loans, 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 are land loans?

A land loan, as its name suggests, is used to finance the purchase of a tract of land. Land loans are a very small slice of the lending market and tend to be riskier for lenders than mortgage loans, explains 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 already-constructed 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 mortgage or 30-year mortgage.

How do land loans work?

Although the requirements and repayment terms of a land loan can be different than a traditional mortgage, the process of applying for one and receiving the funds is somewhat similar. A land loan lender will still usually ask applicants for documentation of their financial situation and run a credit check.

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.

Just like with a traditional mortgage, you’ll usually need to provide a down payment on a land loan, and then pay the balance back with interest over a pre-decided period of time.

5 types of land loans

There are five common types of land loans you can get to finance your 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 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.

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, which translates to lower monthly payments.

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 a couple of loans that can help:

  • 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.

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.

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

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 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.

4. 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 5five years and 30 years.

5. 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 get a land loan

As with any other type of loan, it’s important to shop around. It’s usually a good idea to work with an experienced broker, so do your research to find someone who has worked on land loans in your area before.

If you want to shop around yourself, one place to start is to see if you qualify for any of the government-sponsored loan programs mentioned above. You might also want to get in touch with local lenders and credit unions, who could be more likely to extend you this kind of financing.

Land loan pros and cons

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:

Pros

  • 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

Cons

  • May be difficult to find a lender
  • If you don’t qualify for one of the government programs, you may be charged a high interest rate or need to tap your home equity, which could jeopardize your current property
  • Many land loans have short repayment periods, which means high monthly payments until the debt has been paid off

How to find the right land loan for you

It’s important to shop around to find the best land loan for your situation. Before you do anything else, 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.

Keep in mind 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.”

Next steps

If you already have a land loan secured, you’re probably thinking about building your dream home or some other structure on your new property.

If you didn’t get a USDA or SBA land loan, consider talking to a lender who is familiar with loans for home construction. Check out Bankrate’s guide to home construction loans for more details.

Learn more:

Written by
Zach Wichter
Mortgage reporter
Zach Wichter is a mortgage reporter at Bankrate. He previously worked on the Business desk at The New York Times where he won a Loeb Award for breaking news, and covered aviation for The Points Guy.
Edited by
Mortgage editor