Land Loans: What You Need To Know

by Joe Boylan
Posted: Mar 27, 2021

Introduction: Who Would Want a Land Loan?

When most people think of buying a home, it's usually someone else's pre-existing house that they picture buying. However, resale homes aren't for everyone, and there can be a variety of reasons why. Some homebuyers dislike the idea of living in a stranger's old house, never really feeling like they are in their own home with the ghosts of owners past swirling around them. For other homebuyers, it can be out of fear of not being able to know the true risk of potential home repairs. If the home wasn't well maintained, they may find themselves with costly bills to deal with. Still, other homebuyers may not be able to find anything they want available on the market, a common problem for buyers looking for more modern features in a home.

If any of the above potential scenarios sound familiar, then it might be worth looking into new construction home options. Those that are looking to build a home are going to have a couple of conventional choices available to them; buy a new home from a production builder, or developer, or get rid of the middleman and strike out on your own to build your own house.

If this is you you're going to need some vacant land for your new home. Let's start with the easiest path to finding your own lot to build your dream home.

Buying a New Home from a Production Builder

One of the most straightforward paths to owning a brand-new home is buying one directly from a production builder. This process will most closely resemble the traditional mortgage process, as much of the uncertainty involved with building a custom home doesn’t apply in this scenario.

There are a few things to consider when purchasing a home from a builder, however, and the following may prove informative:

The builder will most often own the lot that they are building your home on. You are essentially ordering a house to be built on the lot and buying the completed package from the builder when the home is complete.
Most new-housing developments will offer a selection of homes limited to only a handful of architectural styles, while others will be completely customizable down to the finishes, it really depends on the builder and how much you are willing to pay.
The process normally involves signing a contract for a house which essentially commits you to buy it from the builder when it's finished.

Building a Custom Home, Yourself

Another option for those looking to own a new home is to custom build one themselves. While this doesn't mean that you will be actually undertaking much of the labor yourself, though doing so can save you money, as you most likely will need to rely on a veteran custom home builder or general contractor in order to secure a loan to finance their home construction.

The process of building a custom home normally involves the following:

Before doing anything else you will need to find, and buy, suitable land to build on.
Next, you will need to develop a rough idea as to what you want in your new home. This doesn't need to be professionally done, but you do need to think about the number of rooms you’ll need as well as what your priorities and budget will be.
Hire a builder. This is one of the most important steps as your builder will not only build your home but often they will be integral in helping you design it as well.
Start building your dream home! One of the best parts of building a new home yourself is the complete freedom you have when making choices as to how your home will be finished. You'll have control over every detail and your only limit will be your budget and your builder's ability, so be sure you will have what you need from both before you start building.

As you can see, both options have their benefits, but if you are thinking of going the custom home route you will need to start with finding and buying a plot of land to build on. While finding a piece of land is easy enough, if you don't have enough cash to buy it outright, you'll need to first secure a loan. This type of loan is often called a "Land Loan" and there are a few things that differentiate getting one from the typical 30-year home loan process.

Don't worry, if this all sounds a little overwhelming, we will break down all the details of land loans, the pros and cons of them, and the steps you can take if getting one sounds right for you.

What Is a Land Loan?

A land loan is used when a borrower wants to purchase land, usually for the purpose of building on it. The specifics of what your loan will look like when you get a land loan will typically be determined by the state of the parcel you are trying to purchase. For example, you can generally categorize land as either raw land, unimproved land, or improved land; and the differences between each will greatly affect the application process you undertake, and the terms of, your loan. Below we will look at the different types of land loans in more detail and how their requirements differ.

Raw Land Loan

Raw land is, in short, just that: raw, unspoiled land. This often means that the lot is remote with no access to publicly maintained roads or other utilities. If you are coming from an existing neighborhood living situation, it may be jarring to consider how you will provide electricity or water for your home, but these are issues that professional builders can easily help you surmount.

In fact, land developers often seek loans for raw land in order to buy a large enough area to create neighborhoods or subdivisions. When developers do this, they often undertake exacting field surveys. Later, they make plans on how they will divide lots, place roads and sidewalks, and install other utilities, all based on the information they've previously gained. Developers do this because they know that building on raw land is very risky and that lenders will want to see a detailed plan before they agree to the terms of a loan.

Because of this, the following can be useful to remember when considering a loan for raw land:

Raw land will often be remote by nature and things like municipal water or waste service may not possible.
Building on this type of land is very risky, and a credit score above 700 is a minimum requirement.
Lenders will want to see a detailed plan for development and often prefer experienced builders.
Because of their risky nature, these types of loans require a larger down payment and often have higher interest rates, between 4.25%-5.25%.

Unimproved Land

Unimproved land is similar to raw land but will generally be more proximate to infrastructure if it isn't already available on the lot. This type of land will often still require basic development work. Although, because these lots will be closer to utilities and roads already, they are an inherently less risky type of loan.

The requirements for this type of loan include:

Having a good building plan and an estimate from builders you would like to use as to total cost.
Very good credit history, scores above 600 are generally required for loans on unimproved land
The down payment for these types of land loans start at 20% minimum.
Likewise, interest rates will be higher than a typical mortgage, around 4%-5%.

Improved Land

Improved land has typically had nearly all of its development work done and is ready to start construction. This means that this type of land will have ready access to roads and other utilities. Improved land will also often have greater access to amenities, which can come in various forms. For example, some developers will offer perks like pools and community centers to attract prospective homeowners.

Some aspects of improved land to keep in mind are:

This type of land is less risky to provide lending for because the heavy lifting of development has been taken care of.
Construction can begin quicker on improved land.
Because it is less risky, the overall purchase price will be higher than that of unimproved or raw land.
Due to the generally less risky nature of loans for this type of land, they will often have lower interest rates and smaller down payments.

Where to Get a Land Loan?

As with any traditional mortgage, it is a good idea to contact local lenders around the area when looking to purchase land. This is because smaller, local lenders will often have a greater knowledge of the area and thus be able to provide a better idea of the value of the lot in question. Local lending institutions may also be able to give advice on any potential issues that may spring up or what problems have been in the past.

So, now that we know local lenders are best, let's look at a few options of where to get a land loan below.

Local and Community Banks

As mentioned above, a local or community bank is a good place to start when looking for a land loan. This is because these lenders will typically be smaller in size, which will naturally make them more risk-averse, so if they won't approve your loan, your loan officer can help you understand why and what to do about fixing any problems like bad credit or looking for other loan options. If you have trouble applying with independent banks, consider going to the local branch of a larger national bank instead, as they may be less risk-averse and offer better terms.

Credit Unions

Credit unions are like banks, except that they are generally operated as non-profit institutions. While this means that credit unions don't need to make a profit on their loans in the same way a bank does, they still do have stringent application processes, especially for riskier investments like land loans. However, for those that qualify, a credit union will often offer more generous terms for lenders. So, if you can get by with fewer financial services than you may get from a bigger bank, then a credit union may be a good option for you.

USDA Loan Programs

The USDA offers loans that are a great choice for those that are looking to build in a rural area, specifically under programs Section 523 and 524. These loans will have stringent requirements, but the programs are surprisingly friendly to those with less than perfect credit and often require little to no down payment. There are also additional programs you may qualify for example, if you are a first-time homebuyer, or if you will maintain the home as your primary residence.

How Do Land Loans Work?

So, now that we know more about some potential places to look for land loan lenders, how do the loans themselves work? Well, the answer depends, as detailed above, on the state of the land you are looking to get a loan for. Additionally, how you are planning on constructing your new home and the actual loan amount will also determine many aspects of your own land loan. However, most land loans will have certain pros and cons in common, such as higher interest rates, which we will look at below.

Interest Rates Are Higher

Interest rates will be higher with a land loan. This is mostly due to the risky nature of lending for undeveloped land because there is little intrinsic value in the land for lenders to use if borrowers default and borrowers are more likely to walk away from a loan for land with nothing on it.

Because lenders view land loans as higher risk, interest rates tend to be higher than a traditional mortgage loan. The better your credit score is and the more favorable your debt-to-income ratio, the more likely you are to find lower rates as well as favorable terms.

The Down Payment Will Usually Be Bigger

The larger the down payment the better, and a sum larger than 20% is often required. This is, again, often due to the heightened risk taken on behalf of the lender.

Terms May Vary

Some land loans will be handled as short-term loans of 2- to 5-years with a balloon payment. This length of the loan term is more typical of riskier land loans where the chances of speculation are greater. However, if you can show you are planning on using the land to build your primary residence, you can often find longer-term options akin to a typical mortgage loan length.

Pros and Cons of Land Loans

While the specific terms will vary from case to case, the following pros and cons can generally be attributed to most land loans.

Pros:

There are government programs, like those offered by the USDA, that offer loans with low-interest rates and no down payment.
By combining the two, land loans often simplify financing the cost of purchasing land and constructing a new home.
The loan can be tailored to your specific needs and circumstances.
One of the biggest benefits of getting a land loan and actually paying it off is that the equity you have in that lot can be used as a downpayment for your construction loan. Construction loans also require at least 20% down and in most cases, the land value ends up covering this. While getting to this point is hard work, it pays off when you transition to your permanent loan.

Cons:

Can be more difficult to find a lender due to the risky nature of land loans.
If you don't qualify for government financing you may be stuck with higher interest rates or take out a loan on your existing assets, putting them at risk.
If your land loan has a short-term you may have higher monthly payments over a shorter period of time than usual until your debt has been paid off.

Other Options

If a typical land loan doesn't seem like it will work for you, don't worry, there are other options you can use to finance the purchase and construction of your new home.

If you already own a home, your best option may be to draw on your existing home's equity by taking out a home equity loan. This is essentially a home equity line of credit or HELOC which many people use for home repairs or updates but it may make sense to use one for a land purchase, especially if you can’t find favorable loan terms.

Your final option, if obtaining traditional financing is looking implausible, is to ask the seller if they would be willing to finance the sale with you directly, in a process known as a seller carry, or seller financing. This option will of course be contingent on the seller being willing to consent to this type of sale, as it will typically involve the seller carrying the note for at least two years, with a large balloon payment often being made after several years' time. They will most likely have even higher down payment requirements than a local bank as well.

Conclusion

So, as you can see, getting a land loan is different than getting a typical mortgage. They will require more capital in terms of higher interest rates and minimum down payments. You also may have a harder time finding a lender or getting a long-term loan. And the amount of time and effort you will have to spend on planning and working with builders is also obviously greater. Yet, as we hope you have come to agree, getting a land loan is not impossible and if you truly desire to live in a brand-new home of your own, then they are one of the best ways of achieving that dream.