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Jason Stauffer is a personal finance reporter who previously covered the housing and mortgage market for NextAdvisor.…
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If you dream of buying that plot of land up in the mountains to one day build the perfect family cabin or retirement home, you’ll probably need a land loan.
Land loans are different from mortgages, so if this is an option you’re considering, there are a few things you should know beforehand. For one, these types of loans aren’t as easy to find as a traditional home loan, and “…the financial tools for buying land, and then building, have always been a lot less conventional than getting a typical mortgage,” says Alec Hartman, CEO of the online residential real estate platform Welcome Homes.
Financing the purchase of land is riskier for the lender — so don’t expect to get the record low mortgage rates that have been stealing the headlines. Land loans usually have higher interest rates, require larger down payments, and offer shorter repayment terms, too.
With a land loan, you can borrow money to buy the land, but it won’t cover the cost of building a home. To do that, you’d need to get another loan down the road whenever you’re ready to build. Or you can skip the land loan altogether and pay for the land purchase and building at the same time with a construction loan. So before you move forward with a land purchase, you need to consider why you want the land and if a land loan is the best option for you.
A land loan is money you borrow to purchase land. Land loans differ from mortgages because you’re purchasing a plot of land that contains no structures. And just like with traditional mortgages, the property you’re buying will influence the type of loan you need.
Loaning money for land is riskier for a bank, in part, because it’s more difficult to sell land than it is to sell a building. So it’s harder for the bank to recoup its money if you default on the payments. On top of that, there are classifications of land that have additional considerations. Purchasing a lot of land in a pre-planned development is different from buying acres of woodland with no road access.
A raw land loan is used for land that has little to no improvements. Raw land typically lacks access to roads and public utilities such as electricity and water. “That type of product is more difficult to get financing on,” says Kirk Pugh, co-founder of the Wilmington, North Carolina-based KBT Realty Group.
Lending money to purchase raw land is riskier for the banks since raw land isn’t as easy to sell. So you’ll usually have to put more money down. “Typically, the loan-to-value requirement is strict and the loans are more short term,” Pugh says. A loan for raw land may require a down payment of no less than 25% to 35% for a 2 to 5 year loan with the balance due at the end of the term as lump-sum balloon payment.
An improved land loan is used for property that has access to roads, electricity, and public sewers but doesn’t have any structures. A lot that’s part of a larger real estate development is an example of improved land.
Improved land usually is more expensive than raw land, but it can be easier to get financing for. “If you’ve got a neighborhood with 500 homes and they’re all contributing to a homeowners association that helps maintain the roads … banks look more favorably on that type of product, because the value is being supported by the neighbors around it,” Pugh says.
If you want to build right away, a construction loan may be better than a land loan because you can fund the land purchase and home construction at the same time.
While getting a land loan is a similar process to qualifying for a mortgage, there will likely be a few extra steps. Not only that, but most of the bigger nationwide lenders won’t even offer land loans. “The types of loans available for straight-up land purchases are few,” says Hartman. So to find a land loan you may need to work with a local lender, like a bank or credit union. If possible, find a broker or loan officer with experience handling land loans and the unique challenges that come with them.
The lender will need to review your finances, including your credit score and income. You can expect lenders to have higher standards for land loans, compared to home loans. So you’ll need a bigger down payment and higher income to qualify.
The property itself may even be scrutinized in more detail. You’ll go through the standard processes for assessing the property, with an appraisal and title search. But you also may also need to have the land surveyed or to verify any zoning or land use restrictions.
Land loans allow borrowers to purchase land without having to pay 100% of the cost out of pocket. This gives homebuyers and businesses more flexibility in where they choose to build. But choosing to purchase land comes with a whole new set of challenges that you won’t have when you buy a pre-existing building.
Once you find a few lenders that offer loans for land purchases, make sure to compare them all. You’ll want to pay attention to the cost of the loan, including the interest rate, monthly payments, and fees. In addition, pay attention to the fine print and repayment terms.
Land loans have much shorter repayment terms than traditional mortgages, typically two years to 15 years. Some loans may have smaller monthly payments with a large, one-time balloon payment tacked onto the end of the loan.
Be sure that any land loan aligns with your goals for the property. The best land loan for you is different if you intend to build a home within the next 12 months or buy 25 acres to start a commercial farm.
Purchasing land with the help of a traditional lender, like a bank, isn’t the only way to finance a land purchase. You may be able to find a seller that will finance the purchase, or you may be able to borrow money using other assets as collateral.
Borrowing money to finance a land purchase can be a challenge, but you may have other collateral you can borrow against instead. If you own a home or other property, you may be able to get equity out of your house with a Home Equity Loan, Home Equity Line of Credit (HELOC), or a cash-out refinance. You could then use that cash to pay for land.
Home Equity Loans and refinancing your home both will incur upfront fees, typically 2% to 5% of the loan amount. A HELOC doesn’t have the same upfront fees, but it functions more like a credit card with a variable interest rate, instead of a fixed rate that’s available with the other options.
Using an existing home as collateral will make it easier to borrow money, but it comes with a huge risk: if you can’t make payments, the lender could take your home. So only use this option if you know you can afford it.
In some circumstances, the current owner of the land may be willing to be the de facto lender for the transaction. In this scenario, you’d negotiate the terms and interest rates with the seller, and you’ll typically pay a higher interest rate and have a shorter repayment period.
Seller financing is an option only if the seller currently doesn’t have any loans against the land, so they’ll need to own it outright. This type of financing is more common in a buyers market when sellers are more likely to have trouble finding a qualified buyer.
A land loan is used to purchase land only, not to finance a home build. If you’re not planning to build a home right away, a land loan may be just what you need.
But if your goal is to buy land and put a building on right away, then a construction-to-permanent loan is likely to be a better option. “That’s a single close mortgage, where you close on the property and you also commission the build. That allows you to purchase the land and get a loan to build your house at the same time,” says Hartman.
If you’re planning on building a home within two years of the land purchase, a construction-to-permanent loan is the way to go, Pugh says. A construction-to-permanent loan is a type of construction mortgage that automatically converts into a traditional mortgage once the home is ready for occupancy.
While the home is being built, construction loans function similar to a line of credit, where you’re approved for a certain dollar amount with a variable interest rate and you have a set amount of time, typically a year or two, to use that money to build your home. With a construction loan there is an initial payment made for the land and to the builder. Afterward, the builder could make 3 or 4 draws against the construction loan. These draws are usually negotiated beforehand and coincide with milestones such as completion of the foundation, framing, or the roof.
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