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If you’re thinking about building a home or business but don’t have the land yet, a land loan may be the perfect answer. You’ll get financing to secure the land needed to construct your building, but it comes at a cost.
Here’s everything you must know about a land loan.
What Is a Land Loan?
As the name suggests, a land loan is a loan to buy land, but only land. You can’t use it to buy land with a property on it or to buy land to build a property on it right away. If you’ve found land you want and plan to build on it in the future, a land loan may be your best option.
How Do Land Loans Work?
Since there is very little collateral in a land loan, lenders typically require a hefty down payment. It’s not unusual for a lender to require a down payment of 30% – 50% and to provide shorter terms than a typical conventional loan.
You’ll typically pay much higher interest rates on the loans, too, because of the risk. If you couldn’t make your payment, you wouldn’t lose the house you live in – you’d just lose the land. Lenders make up for this risk by charging much higher interest rates.
How to Get a Land Loan
Applying for a land loan is much like applying for a mortgage loan. You must prove you can afford the payment, have a high enough credit score to show creditworthiness and show how you’ll use the land.
It’s easiest to secure a land loan from local lenders, especially credit unions. You want someone familiar with the area and the potential of the land.
Your intended use for the land will determine how many options you have, including a USDA loan.
9 Different Types of Land Loans (and Alternatives)
Before you can take out a land loan, you must know how you’ll use the land, so you take out the right type of loan.
#1. Raw Land Loan
Raw land is the most difficult land to get financed because the land is raw or undeveloped. Raw land doesn’t have sewers, roads, or electricity.
You can increase your chances of approval by making a large down payment and having a solid plan on what you’ll do with the land. Lenders like to see that you have a plan and will develop the land sooner rather than later.
#2. Construction Loan
A construction loan isn’t a loan on the land but rather money to finance the home’s cost.
Construction loans cover the cost of materials and labor, but they are a temporary form of financing.
Most construction loans are good for the short term and not meant to be the long-term financing needed to live in the home.
You must convert the loan to a permanent mortgage once the home is built and you have the occupancy certificate.
#3. Unimproved Land Loan
An unimproved land loan is on land that is slightly more improved than raw land but not completely improved.
It may have some utilities, but not all, and it isn’t ready to be built on yet. Like a raw land loan, you must prove you have plans for the unimproved land, and again, a large down payment will help.
#4. Improved Land Loan
Improved land is the opposite of raw or unimproved land. It already has roads, utilities and is ready to be built on.
Improved land costs more than raw or unimproved land, but it’s often easier to get approved for since there’s much more anyone can do with improved land, not unimproved or raw land.
#5. Lot Land Loan
Lenders offer the most flexible guidelines on lot land loans because it means the land is zoned for homes (typically) and ready to build on.
It’s obvious what you’ll do with the land, and even if you don’t and you default, the lender should be able to sell the land to someone who wants to build on it.
#6. Home Equity Loans
If you own a home with equity in it, you can use the equity to buy land. A home equity loan is the easiest way to secure a land loan because you don’t have to disclose what you’re doing with the funds.
Your home is the collateral for the home equity loan, not the land, so the lender doesn’t have to care what type of land it is.
#7. Seller Financing
Some sellers will offer financing, especially if they know the land will be hard to finance through a bank. Seller financing terms are different for each seller.
Consider the term (how long you have to pay it off), the payment, interest charges, and any other terms the seller wants before choosing this option.
#8. SBA 504 Loans
If you intend to use the land for business use, you may be able to get a Small Business Administration Loan.
The 504 loan requires a 10% down payment from you, the SBA contributes 40%, and the lender providing the loan provides the remaining 50%.
#9. USDA Rural Housing Site Loans
The USDA provides financing for rural areas, and this includes land. The USDA offers two options – the 523 loan is for borrowers who will build their own home, and the 524 loan is for borrowers using a contractor to build the home.
Land Loan Rates
Land loans are riskier for lenders, which means they charge higher interest rates, just like when you buy a house, and you pay a higher rate if you have bad credit or other risky factors. The same is true of land loans.
The fact that you’re just buying land and not building a house on it immediately is risky for lenders. Expect to pay at least 2 – 3% more than typical mortgage loan interest rates today.
>> More: How Are Mortgage Rates Determined?
How to Choose Your Land: Factors to Consider
Before you choose land, consider the following factors:
Surveying and Boundaries
Never buy land before you know the boundaries. The only way to know the boundaries is with an official survey.
Most of the best mortgage lenders require an American Land Title Association Survey before they’ll approve your loan.
Zoning and Restrictions
Always know the zoning of the land. You may have great plans for the land, but if they don’t fall within the designated zoning, you could be left with land you can’t use.
Know the conditions of the land and any environmental restrictions it has. Knowing any restrictions upfront ensures that you can use the land for your intended use and prevents you from buying land you can’t use.
If you’re buying anything except raw land, make sure the land already has the necessary utilities. If it doesn’t, make sure there’s room in your budget to cover the cost of adding them.
Find out if there are any plans to make major changes in the area, including adding public transportation, retail establishments, or any other major structures that could affect your land and its intended use.
What Are the Advantages of Land Loans?
Land loans have limited use since you can’t use them to buy a home, but if you’re in the market for a land loan, here are the advantages:
- You can buy land and do what you want with it. When you’re ready to build your dream home, you’ll already have the land.
- They are helpful for small business owners trying to expand or get their first place of business.
- There are many options if you shop around, including loans with down payment assistance from the government.
What Are the Disadvantages of Land Loans?
Like any program, there are disadvantages of land loans too:
- The interest rates and terms are much less attractive than traditional mortgage financing.
- It may be harder to find a lender
- The monthly payments can be high because the terms are usually short.
Bottom Line: Lands Loans
Before you commit to building a home or building for a business, make sure you can afford the land.
If you can’t pay for it in cash, you’ll need a land loan with much different terms than a traditional mortgage.
Shop around and compare online mortgage lenders to get the best rates and terms and find the loan that’s most affordable for you.