- Also known as lot loans, land loans can help you finance the purchase of a plot of land.
- There are different types of land loans available depending on how developed the plot is, and requirements can vary by type.
- Land loans can come with stricter eligibility requirements and higher interest rates than traditional mortgage loans.
A land loan is a type of financing that borrowers can use to buy a plot of land for residential or business purposes. You'll typically consider this type of loan if you want to purchase some land but don't plan to build on it right away. If you are planning to start construction shortly after the purchase, you may consider a construction loan instead.
You can typically obtain a land loan from a bank or credit union, via seller financing or through the U.S. Department of Agriculture (USDA), which offers options for homebuyers with low to moderate income who are planning to build a home in an eligible rural area.[2-5]
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How does a land loan work?
A land loan functions similarly to a traditional mortgage loan in that it offers a lump-sum payment to aid in the purchase of a plot of land. "It could be a lot in a subdivision or thousands of acres," says Casey Fleming, a mortgage advisor and author of The Loan Guide. You'll then pay back the debt over a set period.
Depending on your situation and the lender, repayment terms on land loans may range from a couple of years to 20 years, and they may or may not include a balloon (or big) payment at the end of your term.[2, 5]
Because there's no home to use as collateral, though, land loans tend to be riskier to lenders than mortgage loans. As a result, you can generally expect stricter underwriting guidelines and higher interest rates.
Depending on where you go, you may find minimum credit scores in the upper 600s or lower 700s, and you may need to make a down payment of 15% or more—according to Fleming, a 35% or even 40% down payment is not uncommon. Interest rates are typically upwards of 6%, though yours will depend on your creditworthiness, income and down payment, among other factors.[2, 6-7]
You'll also want to have a clear plan for development or construction on the land to provide to the lender. This is particularly important with less developed lots.
Types of land loans
There are three different types of land loans, including raw land loans, unimproved land loans and improved land loans. Here's a quick summary of how they differ[5-6]:
Raw land loan: These loans are designed for land that has no developments, such as electricity, roads and sewer. It's difficult to obtain this type of loan because building on the plot is a much more involved process, so expect higher down payment requirements and interest rates compared to the other options.
Unimproved land loan: Unimproved land typically has some development but may lack some utilities and amenities required to be fully improved. These loans aren't as risky as raw land loans, but they still require higher down payments and have higher interest rates than improved land loans.
Improved land loan: With this type of loan, you can purchase land that has the developments required to construct a proper home or business. The land itself is typically more expensive than raw and unimproved land, but you may not need to put as much down or pay as high of an interest rate. "You would typically find improved land where a developer has taken a large piece of raw land, subdivided it into lots and installed improvements, and is then selling off the improved lots," says Fleming.
Note that USDA rural housing site loans offer lower down payments and interest rates than loans offered by private lenders. But these loans have just two-year repayment terms, and you'll need to meet separate requirements, particularly regarding income and property location.
Pros and cons of land loans
If you're thinking about buying land to build your home or business, it's crucial that you understand both the benefits and the drawbacks of using a land loan to finance the transaction. Here's what to consider:
- Provides an option if you’re short on cash: Land can be expensive, but you can't get a traditional mortgage loan with no home, and you can't get a construction loan unless you plan to start building immediately. If you want to buy some land for future use, this option can help you achieve your goal without needing to shell out a lot of cash.
- Gives you flexibility: Buying a plot of land instead of an existing home or business location gives you the flexibility to develop the property as you want.
- Government loans can be relatively affordable: If you qualify for a USDA rural housing site loan, you can avoid some of the more expensive lot loan options.
- Can be expensive: Land loans carry higher interest rates and shorter repayment terms than traditional mortgage loans, so you'll want to make sure that you can afford the monthly payments. Double-check your budget and cash-flow to confirm affordability.
- Can be tough to obtain: Not all home lenders offer land loans, and even if you find ones that do, you'll need to meet higher credit requirements and put down more money, especially if the land isn't developed.
- You may run into complications: Building on an empty plot of land can come with additional complications, including surveying and permit requirements, developments and more. Even with the best plans, it's possible to fall short of your expectations and still be left with the land loan to repay.
Unimproved land loan vs. improved land loan: What's the difference?
The difference between these two loans isn't in how they work but what you can use them for. An unimproved land loan is designed for land that may have access to certain utilities and amenities, but it lacks full development.
In contrast, an improved land loan is for lots that are fully developed with road access, utilities and other necessary amenities.
Because improved land has fewer obstacles to constructing a home or business, loans tend to carry less risk than unimproved land loans and, therefore, have lower interest rates and down payment requirements.