What Property Buyers Should Know About Land Loans | The Simple Dollar

What Property Buyers Should Know About Land Loans | The Simple Dollar

The idea of building a dream home on a new plot of land inspires many future homeowners. There’s something exciting about the prospect of finding the right spot to build on and customizing everything in your new home.

But while it’s not uncommon for potential home buyers to opt into building a home, the land loan process to finance the purchase of the land you’re building on is not as simple of a process of getting a conventional home loan. With a conventional loan, the process of obtaining financing is fairly straightforward. You just apply with a few lenders, get the rates and terms for the loan and then close on your home loan a few weeks later.

Part of the reason it’s not as simple is because land loans work differently from a typical home mortgage due to the unknowns involved in building. Land loan rates from banks are also vastly different from what you’d get with a conventional loan, in large part because risks are higher and there is no existing structure to use for collateral. So, if you’re thinking about buying land to build on, here’s what you should know.

What is a land loan? 

Land loans are used to finance a purchase of a parcel of land when there is no existing structure on it. The value of the land is harder to determine, since the usability of land for particular kinds of construction is very relevant to its value.

For instance, your lender will need information that includes the actual surveyed boundaries of your desired property, as well as what kinds of hook-ups to utilities are available on the property. If, for example, you will need to put in roads or driveways over other people’s land to get road access, that will impact the value of the property to the lender. You’ll have to get legal permission to create the roads or access on someone else’s land, and therefore the lender would be taking a risk to work with you.

For this reason, different types of land loans will have much higher down payments requirements than others. If you’re purchasing raw land, which has no road access and no utility connections pre-existing on the land, you could be required to make a down payment of 50% or more to get a loan from a traditional lender.

Because of the risks, not every lender offers land loans. You’ll need to inquire about whether your lender offers them, along with the particulars of the property you are considering, in order to know how much of a down payment and interest rate will be expected.

[Read: Is Building a New Home Better Than Buying an Existing One? ]

How to get a land loan

If you want to obtain a land loan, there are certain ways you should approach it, including:

Make sure your credit profile is in order. Your borrower profile will need to be stronger for approval because the lender is taking a bigger risk when financing these types of loans. Before you speak to any lenders, make sure your credit profile and debt to income ratio, along with the amount you can put down, is going to be enough to get you the loan.

Know what you’re buying. If possible, approach lenders with a particular piece of land in mind, or at least with things like your price range. You should also know whether you’ll only consider property with road access or if you’re expecting access to city water and other utilities.

The lender will also want to know whether you have plans to build immediately or if the land has major issues with things like levelling. Issues like this must be addressed before building and will change your bank’s risk exposure, so they are relevant to the conversation.

Find out all of the details of the loan your lender offers. Begin by talking to the lenders you are considering and ask in general terms how they handle (or do not handle) land loans. Ask about the general hike in interest rates for land loans and inquire about what kind of down payment you can expect.

Understand the closing process and time frame. If you have the qualifications and the loan terms are reasonable, you can purchase the property using your land loan, but make sure you get clear information on everything related to the loan. This includes closing costs and time frames, since they may not follow the traditional mortgage loan path. You don’t want to get caught by surprise down the road.

Consider alternative financing methods. If you aren’t satisfied with the offers you get for your traditional land loan rates and options, consider seller-financing or talking to a local credit union. Credit unions can sometimes offer options that are more favorable for land loans.

What are the types of land loans?

There are three different types of land loans. The loans are based on the types of land your purchasing, and include:

  • Raw land loan: A raw land loan is meant to finance a land parcel that is completely undeveloped, with no electricity, sewers or roads. Given the hurdles you’ll have to jump through to get the land developed, it can be difficult to get raw land loans. If you want to obtain a loan for completely undeveloped land, you’ll need to have a solid borrower profile and plan for your project. 
  • Unimproved land loan: Unimproved land loans are similar to raw land loans. The main difference is that the land is slightly more developed. That could include access to some utilities or amenities, but it won’t usually include an electric meter, phone box or natural gas meter. These loans are slightly easier to obtain than raw land loans, but not much. You’ll need a solid financial profile and down payment to obtain one.
  • Improved land loan: Improved land loans are used when you’re buying a parcel of land that has access to roads, electricity and water. This is the most developed type of land you can purchase, so it’s going to cost you more to buy. However, it won’t cost you as much in interest, because the gamble isn’t as big for the lender. Your down payment requirement may not be as high as it would be with a raw land loan, either.

[Read: Why You Should Buy Less House Than You Can Afford ]

Tips on land loans

  • Weigh the costs on different pieces of land. Try to price out your project based on what you intend to build with a home construction loan and how much the land will need to be improved to get to the point of building. What might be a good deal on a piece of build-ready property could be highly risky and expensive on another piece of land.
  • Give your timeline some leeway. You want to pad your timelines if you’re borrowing for a land loan. If the money and terms of the loan only work for your cash flow if everything goes perfectly, you may want to reconsider. Projects that require you to improve land before building on it are often delayed, so if you’re in a time or money crunch, you might not want to go this route.
  • Compare offers and ask the seller to help. If you are confident that you’ve found the right piece of land, talk to multiple lenders and to the seller. See if the seller is willing to commit to certain improvements to make it easier to finance the land.
  • Find out what the land around you is being used for. Remember that the land that surrounds your land matters, too. Are there plans for new subdivisions, businesses or other projects? Your local municipality often has this information if permits have been requested or proposals have been suggested for particular projects.

[Read: What is a VA Construction Loan?]

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