Guide To Land Loans – Forbes Advisor

If you want to build a house or a commercial property, a land loan can help you secure a location. However, land loans are considered risky investments for lenders because there’s no property to serve as collateral. That means they may be harder to find and qualify for than a conventional mortgage or a business loan.

What Is a Land Loan?

A land loan, also called a lot loan, is used to finance the purchase of a plot of land for residential or commercial development purposes. The type of lot financed can be anything from raw land to a fully developed parcel. However, unlike a short-term construction loan, you don’t need to be ready to build to qualify for a land loan.

Land loans provide an alternative path to homeownership for borrowers who don’t want to purchase an existing property. They also allow entrepreneurs to expand or establish a business on land they own outright, versus pursuing a ground lease.

How Do Land Loans Work?

Land loans are obtained similarly to traditional mortgages but with a few important caveats. Because borrowers are much more likely to stop making payments on a land loan than they are a mortgage for a primary residence, lenders have more stringent qualification requirements. Further, land loans typically have higher interest rates and shorter repayment terms than traditional home loans, meaning you’ll need to be prepared to make higher monthly payments.

Qualification Requirements

Eligibility for a land loan varies by lender. General borrower requirements include:

• Minimum credit score of 720
• Down payment of around 10% to 20%, but as high as 50% depending on the type of land
• Stable income
• Low debt-to-income (DTI) ratio

In addition, lenders may finance a land purchase if you can demonstrate a plan for how you’ll use the property. This could include plans to build a house or commercial property, start a farm or use the land for recreational purposes.

Lending Process

After the borrower qualifies, the lender determines the loan rate. Following that, the first down payment is due with an established interest rate. However, after the home’s construction, the loan can be refinanced into a traditional mortgage package. This process is favorable for those looking for a new principal balance and a lower interest rate.

Refinancing can include reamortization, which changes the number of years required to repay a loan, or repricing, which adjusts the interest rate in favor of the buyer.

3 Types of Land Loans

There are generally three types of land for which lenders may offer financing.

1. Raw Land Loan

Raw land is undeveloped and lacks amenities such as plumbing, electricity and road access. This type of land tends to be the cheapest, but the costs of preparing the land and adding infrastructure can add up over time. Raw land can be riskier than other types of land loans and often require higher down payments—up to 50% in some cases.

2. Unimproved Land Loan

Unimproved land is a slight upgrade over raw land. For instance, this type of land may have access to some basic utilities while still requiring sewer and electrical hookups.

3. Improved Land Loan

Improved land already has the necessary infrastructure to support the construction of a home or commercial building, such as paved road access and electricity, water and telephone connections. As such, improved land is the most expensive type of land but usually the easiest to finance.

Pros and Cons of Land Loans

As with any type of financing, there are advantages and disadvantages to land loans.

Pros of Land Loans

• Land loans give you the opportunity to build a house or another type of property to your exact specifications.
• You can refinance these loans into a construction loan when you’re ready to build (and a traditional mortgage once your home is complete).
• They don’t require private mortgage insurance (PMI) or other insurance.
• Borrowers who plan to delay construction are ideal for land loans.

Cons of Land Loans

• Land loans can be hard to find because many lenders don’t offer them.
• Borrower qualifications are more stringent compared to those for a regular mortgage.
• You may face less favorable loan terms, such as higher interest rates and down payment requirements.
• Land loans typically have shorter repayment periods than a mortgage, increasing your monthly payment amount.
• They often include a balloon payment—a large one-time payment due at the end of the loan term.

How To Get a Loan for Land

Not all lenders offer land loans, so it’s important to do your research to find a lender that specializes in this type of financing. Be sure to compare interest rates, fees and other loan terms from multiple lenders to find the best deal.

Prior to applying, you’ll want to:

• Determine how you’ll utilize the land. Without a plan, you might not be able to buy land. Most lenders will want a development plan before approving a land loan, even if you don’t expect to build right away.
• Check your credit score. Your credit score plays a significant role in determining your eligibility for a land loan and your interest rate. If your score is below 700, establish a plan to improve it, whether that includes paying off existing debt or waiting for past late payments to fall off your credit report.
• Find the land or lot you’re interested in purchasing. Some lenders may offer preapproval for a land loan, which determines upfront how much you’re able to spend on the site for your future home.

When you’re ready to apply, consider the following sources for your land loan.

Local Banks and Credit Unions

Local banks and credit unions are more likely to offer land loans than traditional national banks. That’s because they’re more familiar with the land and better equipped to assess its value and potential.

U.S. Department of Agriculture

The U.S. Department of Agriculture (USDA) offers two loan programs for low- and moderate-income borrowers who want to build a primary residence in a rural area. If you intend to build a home yourself, you’ll apply for a Section 523 loan. These come with an interest rate of 3%. If you plan to hire a contractor, you’ll opt for a Section 524 loan, which charges interest based on current market rates. Both loans are for two-year terms.

U.S. Small Business Administration

If you plan to use the land for business purposes, the U.S. Small Business Administration (SBA) provides two types of loan options:

• 504 loan program. This program offers financing of up to $5.5 million for assets that promote business growth and job creation. Under this program, you need to put down at least 10% toward your land purchase, while a third-party lender finances at least 50%;  a Certified Development Company (CDC) provides up to 40%. Repayment terms of 10, 20 and 25 years are available.
• SBA 7(a) loan. These loans allow you to borrow up to $5 million with repayment terms of up to 25 years. The minimum down payment requirement is 10%, and you may need to provide collateral—something of value that secures the loan and the lender can repossess it if you fail to repay—if you’re financing more than $25,000.

Alternatives to Land Loans

Traditional land loans aren’t the only avenue you have for purchasing land.

Seller Financing

Seller financing, also known as owner financing, allows borrowers to purchase land directly from the seller without relying on traditional financing. While this can be favorable if you don’t meet the typical requirements for lender financing, seller financing often includes higher interest rates.

Home Equity Loan

If you have enough equity in your home, a home equity loan may be viable to either finance a land purchase outright or provide a down payment on a land loan from a bank or credit union. However, you’ll be risking your primary residence should you default on your payments.

Personal Loan

A personal loan is a type of lump-sum financing you can use for many purposes, including land. Because they require no collateral, personal loans can help you finance a land purchase without risking your other assets. However, you’ll typically need excellent credit to qualify for the best personal loan rates.

Government-backed Construction Loans

Construction-to-permanent loans backed by the Federal Housing Administration (FHA), U.S. Department of Veterans Affairs (VA) and USDA include financing for a land purchase, home building and mortgage for the completed home in what’s known as a one-time-close loan.

You’ll need to work with an approved builder to qualify for these loans, which also require an escrow account to distribute funds for the homebuilding process.

Should You Get a Land Loan?

Whether you should pursue a traditional land loan or consider another type of financing for a land purchase depends on how quickly you plan to start construction and your qualifications as a borrower. If you have a sufficient down payment, good credit and clear plans for what you’ll do with the property, a land loan could be right for you.