Land Loans: Learn the Basics Before You Buy Land

Land loans are mortgages used to buy property with no existing structures. Land loans are also called lot loans. You might use this type of loan to purchase land to build a house, for business purposes, or as an investment. 

Land loans pose a greater risk to lenders, making them harder to get. However, if you prepare by understanding the nature of land loans, you can get through the obstacles to getting a land loan. 

This article will help you prepare. Topics covered include:

• What is a land loan?

• Types of land loans

• Land loans vs. construction loans

• How do land loans work? 

• How to get a land loan

• Alternatives to land loans

What Is a Land Loan?

A land loan is a mortgage used for buying land. You’d use some form of land financing when the property has no structures on it. 

Vacant land is harder to appraise and tougher to sell. There is much more reliable demand for properties with ready-made homes or businesses on them. The less reliable demand and uncertainty about future development of the property make land loans harder to get. Also, lenders that offer land loans are likely to charge higher interest rates.  

Types of Land Loans

The ability to build on a piece of real estate goes a long way toward determining that land’s value. Because of that, land loans vary according to how ready for development the land is. 

Raw land loan

As the name suggests, raw land is property in its most undeveloped form. 

This means that in addition to having no structures on it, raw land is not set up to be served by utilities such as gas, electricity or water. There may not even be roads accessing the land.

Because raw land is the most undeveloped, it represents the greatest uncertainty for lenders. That may make this the toughest type of land loan to get. 

Unimproved land loan

Unimproved land is just a step closer to development than raw land. It may be in an area served by roads and utilities, but does not yet have service running to the property.

Getting utilities to serve a piece of unimproved land may seem like just a matter of getting hooked up with the utility companies. Even so, local zoning laws may also be an obstacle.

Zoning laws often limit the purposes for which a piece of land may be developed. Those limitations are likely to be viewed as risk factors by a lender. They are also obstacles you should check out before buying a piece of unimproved land. 

Improved land loan

This can be thought of as the most “shovel-ready” type of land for development. Improved land already has connections to utilities. It just doesn’t yet have any structures built on it.

Improved land is often sold by developers who prepare lots for building and make them ready for utility hook-ups. A lot loan for this property may be relatively easy to get because the path towards development has been cleared. 

Even so, it is vital to check out local zoning ordinances before you buy an improved lot. You’ll need to make sure the type of house or business you have in mind for that lot is allowed by those laws. 

Land Loans vs. Construction Loans

A construction loan is related to a land loan in that it is a mortgage to buy property that does not yet have a structure on it. 

However, a key difference is that construction loans finance the cost of building on the land. So-called "one-time close" construction loans can finance a lot or pay off a land loan as well as cover construction costs and even roll into permanent financing. These loans, if you have an entire project planned out, can eliminate multiple rounds of closing costs. Another name for these loans is “construction to permanent.”

In contrast, land loans only finance the land purchase, not the cost of building on it. 

While it may be easier to finance the purchase of the land and the construction costs all at once, you may not be ready to start building right away. 

You may be buying the land because you want to reserve it for use sometime in the future. Or, you may only be able to afford the purchase of the land at this point and will save towards paying for the construction later. 

If you’re not ready to build, it doesn’t make sense to start paying the financing expense of a loan to cover construction costs immediately. That’s why you may choose a land loan instead of a construction loan in that situation. 

How Do Land Loans Work?

Land loans are like ordinary mortgages in that the property you buy with them secures the loan. However, land loans are harder to find – your friendly bank or credit union may not offer that kind of financing. There are other differences as well.

• Land loan terms are shorter than those of residential mortgages.

• Your development plans may be an issue, so make sure that they comply with zoning laws.

• Expect to make a larger down payment (up to 50%).

• Interest rates run about 3% higher than traditional mortgages.

• Repayment terms are much shorter than those of residential home loans (two to 15 years). 

• You’ll need to be financially qualified as well, with  good income, a low debt-to-income ratio, and an excellent credit score.

Purchasing property with a land loan requires you to pay more out-of-pocket, and higher rates and shorter loan terms mean larger monthly payments. 

How to Get a Land Loan

How you get a land loan depends on your intended use for the land. The sections below will address land loans for future homes and land loans for businesses.

Land loans for future homes

If you are applying for a loan to buy land on which you intend to build a home in the future, part of the approval process is likely to focus on how you will get the home built. This includes developing the site and complying with local zoning laws.

The land value may depend on your ability to follow through on your plans. So, do your research before you apply. Present the lender with details that show you’ve done your homework and that your project is viable.

Your approval is also likely to depend on your personal finances. That includes your credit score and your current income and financial obligations. The lender might want to see that your debt-to-income ratio is low enough so you can afford to finance your future building plans. 

If you’re planning on building a home or homes for low-to-moderate income families in rural areas, consider the USDA’s Rural Housing Site Loan program. 

Land loans for businesses

If your land purchase is ultimately for business purposes, a variety of factors may come into play in getting a loan:

• Whether the business is established or a start-up. If it’s an established business, the credit history or finances of that company have to pass muster. If it’s not for an established business, your personal credit history and financial situation will come into play.

• The cost and feasibility of the plan to ultimately develop the land to meet the purpose of the business. 

• The business plan for making the project profitable enough to contribute to paying off the loan.

There are two government agencies that might be able to help with land loans for business purposes:

• If you’re purchasing the land for farm use, the USDA’s Farm Service Agency might assist you in securing financing.

• For other types of businesses, the Small Business Administration’s 7(a) loan program might help you secure a loan that can be used for a land purchase.

Alternatives to Land Loans

Besides a land loan, there are other loan options you might have for financing a land purchase: 

• Home equity loan. If you own a home with a substantial amount of equity, you might be able to borrow against it to pay for the land. The loan term might be longer, which could make the monthly payments more affordable. A fixed rate home equity loan could be faster and less expensive, but remember that your home will now serve as collateral for your loan repayment.

• Personal loans. Since interest rates on land loans are not as low as for typical mortgages, a personal loan might actually be cheaper or easier to get under some circumstances. This may be especially true if you have some collateral that can be used as security against a personal loan. 

• Construction loans. If you anticipate building within a short time, it may be easier and more cost-effective to finance the land purchase and the building project all at once with a construction loan. 

• Seller-financed mortgages. If the land has a well-motivated seller who doesn’t need to receive the purchase price all at once, they might agree to create a private mortgage loan for you.