What You Need to Know Before Taking a Land Loan

If you want to finance land for residential or business purposes, you’ll probably apply for a land loan (aka lot loan). This article covers the various types of land loans, how to qualify, and land loan alternatives. 

What is a land loan?

A land loan is financing for property without structures (aka buildings). Technically, land loans are mortgages because they are secured by real estate. This means if you fail to repay a land loan, the lender can foreclose and take your property. However, land loans have different terms than traditional mortgages and they are typically harder to get.

Why take a land loan?

One might apply for a land loan to:

• Buy a lot and build a home
• Purchase land and prepare it for development
• Invest in land without intending to build

The type of land and your planned use for it dictate the kind of lot loan you’ll need.

Land isn’t a home – Understanding the basics

Land loans can be tricky even for experienced property investors. For the lender, they are riskier than home loans because demand for land is lower than for finished houses and land doesn’t generate income. 

Getting preapproved for your land loan before shopping for property is smart. However, before applying, you’ll need to decide what land you’ll be buying – raw, unimproved, or improved. 

Raw land

Raw land is unprepared for any development or construction. It doesn’t normally include utility access and may not even be approachable by road. Raw land can be inexpensive to buy but difficult to finance. 

Unimproved land

Unimproved land has access to basic utilities but no meters or phone lines. Being ready for new construction lowers the risk to lenders a bit and makes it easier to find and qualify for financing.  

Improved land

Improved land is fully or nearly ready for construction. Expect it to be zoned for building and there may even be a building permit. An improved typically has a survey report and physical markers indicating its boundaries, as well as access via public roads or through a permanent easement. Expect on-site or nearby access to utilities like water, electricity, or natural gas and access to a public sewer or private alternative.

That covers types of land you can finance. Next we’ll cover other terms you’ll probably need to know about.

Boundaries

Boundaries (also called property lines) establish what you’re getting when you purchase land. Boundaries are defined by surveyors registered by the city, county, or state. When you buy land, if a survey has been done, there will be physical markers around the property and your county records office can provide a paper copy. If the survey is old or can’t be found, you’ll have to pay for a new one if you want to know the legal boundaries around the property. Expect a survey to cost anywhere from a few hundred dollars in a rural area to several thousand dollars in an urban area.  

Zoning

Zoning occurs when a local government restricts how a certain piece of land can be used. Before committing to a plot of land, check with the local planning department about future plans for the neighborhood. You’ll also want to make sure that the zoning allows whatever you intend to build on your property. Your city or county records office can provide zoning maps.

Access

You’ll want to understand a property’s access before pursuing a purchase. If you’re looking in a newer residential community, access by public road is probably not an issue. That’s because most developers work with the local planning departments to make sure lots have good access to public roads. 

Don’t assume that land in older neighborhoods or undeveloped areas has guaranteed access, however. Even if you can see a road right there, it may not be accessible. Even what looks like a driveway from a public street might not grant you access. The driveway or access road may be owned by, or cross land owned by, a neighbor. 

If a lot is landlocked, you’ll need to explore an easement. Easements grant you the right to cross land owned by someone else. They are not always permanent, and they may limit what you can do on the land. If the sole or primary access to your lot is via an easement, have a real estate attorney review it to avoid ugly surprises. 

What types of land loans exist? 

The type of land loan you seek depends on the state of the lot. 

Traditional mortgage lenders

If you plan to finance an improved lot loan, you can approach the same providers of traditional mortgages – banks, credit unions, and mortgage companies. And if you plan to build on that lot right away, consider a one-time-close or construction-to-permanent loan – like those offered by Fannie Mae, the FHA, or the VA. In addition to less paperwork and lower closing costs, these all-in-one loans usually carry the advantages of easier underwriting guidelines and lower down payment requirements, compared to land loans. 

With a one-time-close or construction-to-permanent loan, you get a single loan to buy the land and build the home. During construction, borrowers typically make interest-only payments. Then when construction is complete, the loan converts to a traditional mortgage with principal and interest payments.

Local banks

If you want a straight land loan, there are fewer choices. You’ll probably have better luck with small, local banks than large national institutions. That’s because they understand the immediate area and market. Smaller banks are sometimes more involved in their communities and more comfortable with lending in their neighborhoods. 

USDA rural housing loan

The USDA administers the only government-backed land loan. The U.S. Department of Agriculture (USDA) backs loans for properties in designated rural areas. Borrowers must meet income eligibility guidelines (low-to-moderate income) and plan to build their homes under the self-help program. Those who qualify can get a zero-down land loan. 

USDA land loans have a repayment term of just two years. You’ll either pay off the lot loan in that time or refinance it with a construction or permanent loan. To apply, contact your state’s USDA Rural Development office. 

The USDA’s Farm Service Agency (FSA) also makes farm operating loans to start, expand, or maintain a family agricultural operation. Rates are very competitive.

How does a land loan work?

If you apply for a land loan as part of a construction-to-permanent package, your process will be very similar to that of a standard mortgage application. The main difference is that the lender also evaluates your plans, materials, and builder.

Most programs require you to use an approved contractor, and your builder completes much of the construction-related paperwork. The maximum loan amount and your required down payment are based on the appraised value of the completed project. 

For a straight land loan, you’ll apply with a lender and get an underwriting decision based on your credit, debt-to-income ratio, assets, and property-related risk. Down payments vary by lender, but you can get a general idea of requirements from these minimums established by the FDIC:

• Raw land: minimum down payment of 35%.
• Unimproved land: minimum down payment of 25%.
• Improved land: minimum down payment of 15%.

Most land loans have terms ranging from two to five years. They can be amortized over longer terms, like 15 or 30 years, and terminate with a balloon payment (a larger than usual, one-time payment at the end of a loan). 

Expect to pay higher interest rates compared with residential mortgages.

Getting approved for a land loan

Getting approved for a land loan is similar to getting approved for a traditional mortgage. Construction-to-permanent financing guidelines are nearly identical to those of residential home loans. Straight lot loans can be stricter, especially for unimproved or raw land. 

You complete an application, probably the same Fannie Mae Form 1003 that you’d use for a home mortgage. Lenders pull your credit report, verify your income (with pay stubs, tax returns, and other documents), evaluate your assets (bank, retirement, and investment account statements), trace your down payment source, and have the property appraised. 

Conservative lenders want to see credit scores of at least 720 for land loans, and maximum debt-to-income ratios of 30% to 40%. In addition, you must explain the intended use of the land and its zoning, land-use restrictions, surveyed boundaries, and access to utilities.

Pros and cons of land loans

Land loans aren’t the only way to finance land, but they’re popular. These pros and cons apply to straight land loans, not to construction-to-permanent financing. 

Alternatives to a land loan

Land loans aren’t the only way to finance a lot purchase. Here are a few less obvious sources of funding.

SBA 504 loan

The SBA 504 loan allows small businesses to borrow up to $5 million for major improvements. Eligible projects include the purchase or construction of: 

• Existing buildings or land. 
• New facilities. 
• Long-term machinery and equipment.

Other eligible uses include improving or modernizing existing facilities, land, streets, utilities, parking lots, and landscaping. You’d have to put 10% down and repay the loan over 10, 20, or 25 years.

Home equity financing

If you find that a land loan for an undeveloped lot is very difficult to get, one alternative is a home equity loan against your primary residence. Home equity products have (usually) fixed interest rates and terms of up to 30 years. Home equity lines of credit (HELOCs) usually have variable rates, but some come with fixed rates or the opportunity to fix your rate during its term. 

Make sure you can afford this loan because you’re at risk for a home foreclosure if you default. 

Seller financing

Getting financing from the seller can offer a few advantages. You won’t have to brave skeptical underwriters, and you may be able to negotiate lower interest rates and closing costs. The process will probably take less time, and you can create an agreement that’s more flexible than you might get from a lender – for instance, five years to develop raw land instead of two. 

Personal loans

The personal loan is another option that can be quite affordable, especially if you have excellent credit and the loan amount isn’t too high. The main advantage of a personal loan is that it’s usually unsecured and quick to close. The lender doesn’t care what you’re going to do with the land or if it’s unimproved. Personal loans come in amounts ranging from $1,000 to $100,000, with terms from one to 12 years. 

Paying cash

Cash can be the right solution if you’re buying in a seller’s market because you can move very quickly. Paying in cash can also improve your negotiating power and save you interest charges.