“Buy land; they’re not making it anymore.” In the competitive world of real estate, these words by Mark Twain are especially true today. Buying land can help you realize your dream of building a home or a commercial property.
While buying land, you’ll need to apply for a land loan to fund the purchase. In theory, land loans seem similar to home mortgages. The truth is, they’re more specialized and harder to obtain than you think.
In this article, we’ll help you understand:
- What land loans are
- How they work
- The types of land loans
- Land loan requirements and qualifications
- Financing options
What Are Land Loans?
A land loan is a type of financing used to purchase a parcel of land for future development – either residential or commercial. To qualify for a land loan, you don’t have to be ready to develop the land right away, although having a plan helps. You can develop it whenever you want
When you purchase land, you buy a parcel or a “lot” of land. That’s why land loans are also known as “lot loans.”
Lenders often see land loans as risky ventures. As in the case of home mortgages, no tangible property serves as collateral. This complicates obtaining a land loan, which has stringent eligibility standards.
The chances of loan approval also depend on the land loan you want to apply for. Let’s look at the types of land loans to understand this better.
Types of Land Loans
Land loans vary per geographical and utility features of the land parcel you wish to buy. There are three main types of land loans:
Raw Land Loans
Raw land is one of the cheapest types of land you can purchase. However, they lack key features, making them a risky land loan proposition. Raw land has no road access, nor does it have utility features, including:
- Electricity
- Plumbing
Developing raw land also requires a hefty investment. Over time, you need to equip it with the necessary utility connections and infrastructure. The costs of developing raw land can add up quickly, making lenders wary of investing in such a risky project.
If you do find a lender who’s ready to back your raw land purchase, you will need to fulfill stringent requirements.
- Characteristics/Challenges of Raw Land Loans:
- Higher down payment: Raw land loans often need a higher down payment than other types of land loans. You will have to pay a substantial sum, possibly up to 50%
- Mortgage rate: Expect to pay a higher monthly mortgage for raw land.
- Viable plan: To approve the loan, lenders will want a cost development plan for your raw land.
- Credit score: Your chances of securing a raw land loan are higher if you have a high credit score.
Unimproved Land Loans
Unimproved land loans are similar to raw land loans, but they have some redeeming features that make them less risky. Unimproved land features a few basic utility hookups and amenities. They still lack essential amenities, for example, appropriate plumbing outlets or electrical connections.
Remember that this land is still “unimproved,” so you will incur substantial costs to develop it and add infrastructure at some point.
All of the above make this proposition unappealing to the lender, imposing strict loan conditions on the borrower.
Loan Requirements
- A high credit score is a must, the same as raw land loans.
- Higher land development costs mean a higher down payment, i.e., at least 20%.
Improved Land Loans
This type is the most attractive of all land loan projects. While securing a loan for this land is easy, it is more expensive than others. Improved land is a viable parcel of land equipped with the following:
- Infrastructure
- Essential utility connections such as electricity and water
- Paved road access
- Telephone connection
- Gas connection
The bottom line is that with improved land, you can begin either residential or commercial development because the basics are taken care of. This kind of “primed land” also puts lenders at ease, making land financing a breeze.
Improved Land Loan Requirements
- There are no stringent cost plan requirements as the land is construction-ready.
- Improved land loans require a smaller down payment than other types of land.
- It has a lower interest rate, but do note that the mortgage is still higher than regular home loans.
How Do Land Loans Work?
In principle, obtaining a land loan is similar to a home mortgage. The basic process is the same, which includes applying for a loan with a lender. You may be assigned a loan officer to help you understand your qualifying criteria and perform credit checks.
If your loan meets approval, you receive the funds to support your land purchase. Ultimately, you pay your lender a monthly mortgage with interest over the years. Lenders are typically banks, credit unions, or government organizations.
However, you can’t rely on regular mortgage lenders to offer land loans as easily. This is because land doesn’t have collateral that the lender can seize if you default on a payment.
Borrowers can stop making monthly payments as they have nothing to lose. As a result, lenders impose stringent qualifying criteria and conditions if you want to secure a loan for land. These may include:
- Higher mortgage rates
- Shorter repayment terms, meaning higher monthly payments
- Above average credit score (typically above 700)
- A plan that illustrates how and for what purpose you intend to use the land
Let’s understand the exact qualifying criteria for a land loan.
Qualifications and Requirements for Land Loans
You should be aware of all the strict qualifying criteria if you’re applying for a loan for a land purchase.
Credit and General Requirements
Not all lenders are the same. Whether or not you will be eligible for a loan will depend on specific qualifying criteria outlined by your preferred lender. But here are some basic lender requirements to know about:
- The down payment for a land loan can range between 10% to 50%. It depends on the type of land (raw, unimproved, or improved) you want to purchase.
- You need a credit score of at least 720
- You must have a low debt-to-income (DTI) ratio, preferably 43% or lower. Lenders can use this ratio to determine your ability to make monthly payments. Use a DTI calculator to check yours.
- You should be able to prove to your lender that you have a steady monthly income.
There are a few lenders in the market who will finance land purchases, so ensure you shop around before settling on one. For the best deal, research and compare loan rates, eligibility criteria, and repayment terms from various lenders.
Property Checks and Intended Use
If you’re thinking of buying a parcel of land without any plans for its use, think again. Most lenders need to know that you have a viable land development plan. Even if you don’t execute it instantly, you will still need a plan to show lenders how you will use it.
That’s because lenders need to know what they’re financing and whether the land has future value. Lenders may also request property details, requiring you to check:
- Zoning
- Boundary surveys
- Land use restrictions
- Utility and road access
Down Payment Standards
Lenders have different down payment standards. They depend on the type of land you intend to purchase. However, the Federal Deposit Insurance Corporation (FDIC) has established broad down payment standards for each land type:
- Raw land requires a down payment of at least 35%.
- Unimproved land requires a down payment of at least 25%.
- Improved land requires a down payment of at least 15%.
Advantages and Disadvantages of Land Loans
If you’re wondering whether land loans are worth the hassle, here’s what you need to know:
Pros of Land Loans
- Land loans are flexible. You can always refinance land loans into construction loans if and when you’re ready to develop your land. You can even refinance this loan into a traditional mortgage if you build a house on the land.
- A land loan allows you to build your dream property, residential or commercial, exactly how you want it.
- You don’t need to buy mortgage insurance while securing a land loan.
- You can enjoy lower interest rates and affordable down payments if you qualify for a land loan from government programs like the USDA.
- Buying land with ready-to-build lots is cheaper than buying a home in some states.
Cons of Land Loans
- Not all lenders who offer traditional mortgages offer lot loans, limiting your lender options.
- Some land loans may require you to use your primary home as collateral. You risk losing your home if you fall behind on your monthly payments.
- Land loans have stringent qualifying criteria.
- You need to agree to shorter repayment terms for a land loan. This means paying higher monthly payments, which is unfavorable to most borrowers.
- Some land loans involve a “balloon payment” or a lump sum amount due toward the end of the loan term.
Financing Options and Sources of Land Loans
Even though the pool of land loan lenders is small, there are reliable alternatives you can choose from, including:
- Traditional and specialized lenders like credit unions and small banks
- Government organizations
Credit Unions and Local Banks
Some big banks are averse to land property loans due to their potential risk. However, you can depend on small local banks for a smoother land loan process. Local banks have the requisite property knowledge of their local areas to understand your loan needs. As a result, they often offer better repayment terms.
Credit unions and financial cooperatives are other traditional entities to consider. If you’re a credit union member, you can apply and request them to green-light your loan for land purchase.
As a borrower, you’ll need to prove your creditworthiness and present an airtight loan proposal.
Government Programs and Alternative Options
Alternatively, you can consider these government programs to see whether you qualify for a loan:
USDA Loans
You may qualify for a USDA loan if you plan to build a residence on your land parcel. The USDA offers two loan programs:
- Section 523 loan: For low-to-moderate income borrowers who want to build a home on a rural land plot. This loan offers a 3% interest rate for a two-year term. It only applies to self-built residences.
- Section 524 loan: This is also a two-year term loan with below-market interest rates for low-to-moderate-income borrowers. There are no restrictions on the construction method for the home, so long as it’s in a rural area.
U.S. Small Business Administration
If you want to develop your land for commercial purposes, consider these loan alternatives from the U.S. Small Business Administration (SBA):
- 504 Loan Program: You’ll need to show that your project has major fixed assets that “promote business growth and job creation” to qualify for this long-term loan. If your project meets the above criteria, this program can fund a loan of up to $5.5 million.
You must meet other eligibility criteria, such as SBA size guidelines and net worth requirements. Your company must operate as a for-profit entity to qualify for this loan.
- SBA 7(a) Loan: You can borrow up to $5 million under this program if you’re a small business owner planning to develop a land parcel for commercial purposes. The maximum tenure for repayment is 25 years. You must make a minimum down payment of 10% and provide collateral if your loan exceeds $25,000.
Alternative Financing for Land Purchases
If you buy land you want to develop right away for personal or business purposes, you’ll need financial help. Here’s where construction loans help.
Various Forms of Construction Loans
Construction Loans for Commercial Purposes
- Acquisition, Development, and Construction Loan (ADC): This loan helps you finance the purchase of land, along with improvements or renovations to existing buildings or property on the land. You can only apply for this loan if you’re renovating an already-developed plot.
- Interim Construction Loan: This is a short-term loan covering you for the duration of the construction on your land. Its validity lasts 18-36 months, during which the lenders monitor the construction process. You will typically receive payment in installments for everything, from the materials to labor.
- Land Development Loan: A land development loan helps you cover the basic costs of preparing the site for construction. This includes installing utility features, electrical hookups, plumbing, and other amenities.
Construction Loans for Residential Purposes
- Standalone Construction Loan: A standalone construction loan has two phases. The first part of the loan covers the construction costs on your land.
The second phase is a mortgage you use to repay the previous construction loan. The good thing about this short-term loan is that it requires a smaller down payment.
- Construction-to-Permanent Loan: A construction-to-permanent loan is one of the simplest loans to help you build your dream home. It covers all construction costs during the building phase.
Once the construction is complete, it converts to a traditional or permanent mortgage. This means you can repay the loan in monthly mortgage payments, just like you would if you bought a ready-made home.
The best thing about this loan is that you only have to pay for one set of closing fees.
Equity Loans and Seller Financing
If you want to purchase land without the hassle of a loan, you can look into these options:
Home Equity Loan
Home equity loans require the use of your primary home as collateral. There is no down payment, as your home secures the loan. This way, you can borrow at a lower interest rate.
A home equity loan isn’t as complicated as a land loan, but you should be mindful of these pitfalls:
- The interest on a home equity loan isn’t tax-deductible because you’re using the loan for a secondary purchase.
- Defaulting on a home equity loan can cost you dearly. You can lose your primary residence, so ensure you’re comfortable making monthly payments.
- Your loan repayment duration can range between 5 to 30 years, but depends on the lender.
Seller Financing
Lenders and traditional loans aren’t the only way to fund your land purchase. Many aspiring buyers rely on seller financing. Seller financing means there is an agreement between a seller and the buyer.
In this transaction, the seller is also the lender and conducts the mortgage process directly with the buyer, aka the borrower. These agreements are also known as land contracts.
Seller financing has advantages, especially if you aren’t confident about qualifying for a traditional land loan. This agreement is more flexible as it is between you and the seller. You don’t have to worry about meeting stringent qualifying criteria or making a lump-sum down payment.
As per the agreement, you make monthly payments to the seller until you repay the purchase price.
Despite its simplicity, there are a couple of pitfalls to this arrangement you should be mindful of:
- Seller financing can bring on legal woes at some point, as the land ownership is in a gray area. The buyer gets an equitable title, which means they can enjoy ownership rights. However, the legal titleholder is still the seller, who retains it until you complete full payment.
- Some sellers may also capitalize on your financial desperation and charge you higher interest rates.
If you opt for seller financing, ensure that the contract clearly states all terms without any room for ambiguity.
Practical Considerations and Tips
If you’re seriously considering buying land for investment but don’t have a plan, loan approval can be difficult. Here are some pointers to go about it the right way:
Importance of Planning for Land Use
- Draw a plan:
Ideate your plans for the land before buying it. Remember, your chances of getting a loan are higher if you have a well-detailed plan.
- Hunt for properties:
Once you’ve decided what you want to do with your land, you can start searching for land that aligns with your goals and needs. You can browse websites like Land.com, LandWatch, and LandSearch to find deals.
Some websites also have a “Find agent” option, so you can work with a professional realtor to help you in the land search.
- Shop Around for Land Loan Lenders:
Another tip is to explore all your loan options before applying. If you’ve bought land in a rural area, check if you’re eligible for a government-sponsored loan. You can also seek help from an experienced mortgage broker.
Lastly, don’t forget to check for local loan providers in your area, such as credit unions and small banks. Your chances of getting a loan from these specialized lenders are better.
Related Real Estate Topics
Let’s look at some key themes in the real estate market.
Investment Opportunities in Real Estate
Investing in real estate can yield big returns if you do it right. Here are some top ways to invest in real estate today:
Buy and flip properties: If you want passive income, invest in an undervalued real estate property. Foreclosed properties are often available at discounted rates but require repair. After upgrading the property, you can sell it for a higher price or rent it out to earn a steady income.
Rental properties: Investing in properties with the sole intention of renting them out is another great way to earn passive income. Your property will also appreciate over time.
Online platforms: If you spend time online, why not make money off it? Many real estate investment platforms actively seek investors for their projects. By financing one of them, you can earn monthly or quarterly dividends. There is some risk involved as these investments are illiquid.
REITs: You can invest in real estate without owning tangible property. Similar to stocks, REITs or real estate investment trusts trade on major exchanges. They promise high payouts in the form of dividends.
Trends and Insights in Property Development
The real estate landscape is always changing. Here are some key trends and industry insights:
- The year of the pandemic (2020) saw a huge outmigration, with people moving out of major cities into smaller towns and outlying suburbs. According to a report by PricewaterhouseCoopers (PwC), this trend will continue for the next 3-5 years.
Big city living may have been the trend in the past, but people now crave “middle neighborhoods” with a big city vibe. These communities have lower-priced single-family homes while also offering you basic conveniences like good transportation and cultural and entertainment options.
- Homes are becoming less affordable as mortgage prices continue to rise. As per PwC’s Emerging Trends report, housing affordability in the US is at its lowest level in 30 years.
- Housing supply has increased overall, thanks to the steady pace of apartment construction in 2023. Up until 2022, around 700,000 units were constructed in the US, with 460,000 units added in 2023.
- Many people favor the ‘Sun Belt’ region in the US real estate market. The Sun Belt region encompasses part of the southern US, from North Carolina to California. Young professionals find this region particularly appealing due to its low tax rate and attractive price-to-space ratio.
Build Your Future With Land Loans
Land loans are a more nuanced category but offer flexibility and potential cost savings in the long run. The amount and interest rate depend on the type of loan for land.
The good thing about land loans is that you can choose from several lender options. Although large banks are wary of this risky loan, small local banks and credit unions are specialized lenders you can rely on. You can also check the eligibility criteria for government-approved land loans.
Land loans are a sensible option if you intend to delay construction on your land. However, they come with strict qualifying criteria. Not only that, but their terms are challenging, with:
- High monthly payments
- High down payment requirement
- High credit score requirement
Most lenders encourage having a land development proposal on hand to help with loan approval. This means that if you have a plan for your land, your loan has a better chance of approval.
If you decide land loans are not for you, there are other alternatives you can consider. Construction loans offer financing solutions that are less stressful than land loans. To qualify for construction loans, you must be ready to build on your land when you apply.
You can also consider home equity loans and seller financing.
Applying for a land loan takes time and patience. If you can swing the high down payment and have concrete plans for your land, you can start building your future today.
