What property buyers should know about land loans

If you’re eyeing a piece of land to build a house on or 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, often called a lot 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. How you finance depends on what type of land it is:

• 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 also the easiest to finance.

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 mid-2023, 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.

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 nearly 7.30 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.
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, designed for borrowers who plan to build their own home.
   • Section 524 loans, which allow you to hire a contractor to build a home for you. Both are designed for low- to moderate-income families and have a repayment term of just two years. The interest rates, however, can be low.
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). The interest rate on a 504 loan is based on current market rates.
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.
5. Seller financing: In some cases, the person or company selling the land might be willing to offer owner or short-term financing. However, expect high interest rates and a hefty down payment. Consider this option only if you can’t qualify for any other type of land loan.

Pros and cons of land loans

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.
• 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. 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, develop 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.
2. Search for properties: 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.
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.
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 mortgage 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.
5. Look into construction loans: If you already have your loan secured and didn’t get it through the SBA or USDA programs, consider exploring construction loans.

Remember, each type of loan comes with its own advantages and disadvantages. It’s crucial to carefully weigh your options and choose the one that aligns best with your goals and financial situation.