If you have future dreams of building a home on your own plot of land, a land loan can help you achieve this. While the process of getting a land loan is similar to acquiring a mortgage, it comes with some added challenges. Land loans often require a substantial down payment, have higher interest rates, and shorter loan terms than traditional mortgages. In this article, we cover what land loans are, how they work, and how to get one.
What Are Land Loans?
A land loan is a financing option that you can use to buy a plot of land. You might take out a land loan if you are interested in purchasing land to build a home or to use for a business in the future.
Land loans can be more expensive to obtain than a mortgage loan because they are riskier for the lender. Unlike a mortgage, land loans aren’t backed by collateral. The only thing supporting the loan is the borrower's creditworthiness. Land loans are also more likely than a home loan to go into default. If the borrower is experiencing financial trouble, they will usually prioritize paying off their home mortgage as opposed to making payments on an empty plot of land. Because of these risks, a land loan can be more expensive and more challenging to find.
What Are the Different Options for Land Loans?
When looking for a land loan, there are three types of land that lenders might be willing to finance, including:
- Raw land has no improvements – no utilities (plumbing, electricity) and no access to nearby roads. While raw land can be cheaper to purchase, it can be challenging to find a lender because of the extra risk involved with developing this type of land. With this type of land deal, you will typically have to come up with a larger down payment to compensate for the higher risk.
- Unimproved land may include access to some basic utilities while still lacking a major service like access to a gas meter. While it can be easier to obtain an unimproved land loan versus a raw land deal, it might still be a challenge.
- Improved land has full access to utilities and a public road. The land might cost you more but it will be easier to obtain financing.
How Do Land Loans Work?
The process of applying for a land loan is similar to applying for a mortgage – with a few additional challenges.
A land loan often demands a larger down payment than a traditional mortgage loan – typically 20%-50% of the purchase price. Since there is no collateral backing up a land loan, you can also expect to pay a higher interest rate. Many land loans also come with a shorter repayment term than a traditional mortgage – typically a maximum of 10 years for unimproved land and 15 years for improved land. Some land loans also use balloon payments.
The specifics of how you get a land loan will depend on the type of land loan you want. However, when applying for a land loan, you will need to have a high credit score, and your lender will likely review your debt-to-income ratio. You will also need to explain to the lender how you intend to use the land and if there are any possible restrictions on the land. Your borrower will likely want to know if there are any zoning restrictions, future construction plans (like building a new highway), or if there are any other potential hurdles you may need to jump through during development.
How to Get a Land Loan
When it comes to where you get a land loan, you have a few different options:
Local Banks and Credit Unions
Local banks and credit unions are often a better source for land loans than large banks and credit unions because they are more familiar with the local market and the land you intend to purchase. Many banks and credit unions can make it easy to convert from a land loan to a construction loan when you are ready to start building.
Seller financing is an agreement between two private citizens, the seller, and the potential buyer. This can be a good option if the seller is motivated to sell and doesn’t have a lot of prospects. This can also be a helpful option for buyers who are struggling to get a land loan due to poor credit. Seller financing can be more flexible than going through a bank or credit union – everything is negotiable from the down payment to the interest rate.
USDA Rural Housing Loan
The U.S. Department of Agriculture (USDA) also offers rural housing loans to assist with the purchase and development of housing sites for low and moderate-income families. There are two different types of loans:
- Section 523. Those that want to build their own home.
- Section 524. Those that want to build with the help of a contractor.
SBA 504 Loans
The SBA 504 loan is available to for-profit small business owners. This loan provides long-term (10 - 20 year maturity), fixed-rate financing up to $5 million. A 504 loan can be used in the purchase of land or to improve or modernize the land. This loan is available through Certified Development Companies (CDCs).
Home Equity Loan
A home equity loan allows you to borrow money against the equity in your home. Equity is the difference between the value of your home and how much you owe on your mortgage. A home equity loan comes as a lump sum with a fixed-interest and fixed monthly payments. You can often get lower interest rates with a home equity loan since it is secured against your home. However, if you default on your loan, you risk losing your house.
A land loan and a construction loan are similar in that they both help you to purchase land to build a home on. The purpose of a construction loan is to fund the construction of your house. It is a short-term option suitable for those who have a plan and are ready to start immediately. The loan typically lasts less than a year and when construction is complete, it converts to a regular mortgage. A land loan is better suited for those who want to purchase land and hold onto it until they are ready to build in the future.
Land Loans Interest Rates
Land loan interest rates are often higher than the interest rate on a mortgage because of the risk involved. Your exact rate will depend on several variables including your credit score, the lender, the type of land loan (raw land vs. improved land), what you intend to do with the land, and the term length of your loan. Bank and credit union lenders generally offer higher interest rates than USDA loans.
Should you get a land loan?
If you dream of one day building a home of your own, securing a plot of land with a land loan is the first step to achieving this dream. Obtaining a land loan can be more challenging than securing a traditional mortgage, but it’s still possible.
Like any loan, there are pros and cons. A land loan is a great way to purchase land without restricting its use. However, you will typically need a high credit score and a substantial downpayment to secure the financing. The type of land you hope to purchase will also determine how challenging it is to access a loan.