Sometimes when potential home buyers are looking to purchase a home, it can be common for them to also consider building a home. But the thought of building a home can seem perfect until future homeowners realize what it might cost to build a house. Though building a house can be expensive, there are many ways to make it more feasible for first time homeowners. Land loans are one of these resources. If you’re interested in building a house, chances are you might have to apply for a land loan if you choose to build. While Rocket Mortgage® does not offer land loans, we understand the importance of educating our clients.
What Is A Land Loan?
A land loan is used to finance the purchase of a plot of land. They’re used when a buyer is interested in buying a piece of land to build a home or utilize for business purposes. If you’re interested in obtaining a land loan, the type you take out will depend on where you’re buying land and how you intend to use the land.
The three most common types of land loans are raw land loans, unimproved land loans, and improved land loans.
Raw Land Loan
Raw land is known to be completely undeveloped land with no electricity, sewers or roads. If this is the type of land you’re interested in, you’ll need to apply for a raw land loan. Because it can be hard to get financing for undeveloped land, it’s important that you create a solid, detailed plan for how you want to develop the land. This will show lenders that you’re committed to the project and don’t pose as great of a risk. You can also increase your chances of qualifying if you have a large down payment and good credit. While purchasing raw land can be cheaper than developed land, raw land loans do have higher interest rates and significant down payments compared to other land loans.
Unimproved Land Loan
Unimproved is similar to raw land, but it tends to be more developed. Sometimes unimproved land has some utilities and amenities, but typically lacks an electric meter, phone box and natural gas meter. While an unimproved land loan isn’t as risky as a raw land loan, it can still be difficult to obtain, so make sure you have a detailed plan, large down payment, and strong credit score. Because unimproved land loans aren’t the riskiest type of loan, the down payments and interest rates won’t be sky-high, but it’s common for them to be higher than other types of loan financing.
Improved Land Loan
Unlike raw land and unimproved land, improved land has access to things like roads, electricity and water. Improved land is the most developed type of land, so it may be more expensive to purchase. However, interest rates and down payments for an improved land loan are lower than they are for a raw land loan or unimproved land loan. Nonetheless, it's still important to put down a significant down payment and have a good credit score.
Land loans are obtained in the same way a buyer would obtain a mortgage loan, but unlike receiving a dollar amount assigned to the property, it can be harder to determine what the land is worth because there is no property collateral. This means that land loans are a riskier transaction for lenders, which results in higher down payments and interest rates than a typical home loan.
How Do Land Loans Work?
Because there are different types of land loans, each has its own qualifications for borrowers to meet. However, there are still general guidelines that are taken into consideration when a borrower applies for a land loan. As with any loan, a borrower will need to prove they have an excellent credit score. They will also need to explain their intended use of the land, which can vary depending on what type of loan they’re interested in. Borrowers must also highlight aspects of the property that need to be checked, like zoning, land-use restrictions, surveyed boundaries, and access to utilities. These factors will give lenders an idea of how risky the loan might be.
Once a lender takes these factors into consideration, he or she can issue the rates and obligations of the land loan. Land loan interest rates tend to be higher than mortgage interest rates because they’re more risky. However, a borrower can qualify for lower rates if they have a better credit score and debt-to-income ratio. After the loan’s rates are determined and the borrower has been approved by a lender and agreed to the loan’s terms, the borrower is responsible for making a down payment and paying the loan back with the decided interest rate.
Pros And Cons Of Land Loans
If you’ve considered applying for a land loan, you’ve likely realized that there are some benefits and drawbacks. To help make your decision easier, let’s go over some of these pros and cons and see how they’d apply to your personal needs and financial situation.
If building a home or business is important to you, there are many benefits of applying for a land loan. The biggest benefit by far is having the opportunity to build the home of your dreams. If you’re looking to use the land for commercial purposes, it can also give businesses the opportunity to capitalize on up-and-coming areas. If you have a vision and are creative and patient, using a land loan to build a home or business would be the perfect option for you.
It’s important to understand the realities and drawbacks of applying for a land loan. For example, because it’s a riskier transaction, there is a lack of collateral which makes some lenders less willing to loan to borrowers. When it comes to financing, there is also the potential for a higher down payment and higher interest rates. Because it’s a new construction project, there is also the possibility of experiencing unforeseen complications and other issues.
How To Get A Land Loan
If you’d like to get a land loan, it’s typically easiest to do so from a community bank or credit union located near the land you’re looking to buy. But depending on what you intend to use the land for, there can be other loan options available to borrowers. For example, if you’re planning to build a primary residence in a rural area, you can apply for USDA loans. USDA loans are designed for low to moderate income families and have a repayment term of 2 years. They have low interest rates, and depending on the situation, borrowers may qualify for a loan with no down payment. On the other hand, if you’d like to use a land loan for commercial purposes, you can apply for SBA 504 loans. SBA loans are provided by the U.S. Small Business Administration (SBA) and designed for businessowners looking for funds to help contribute to the cost of the land purchase. The interest rates and terms of SBA loans can vary, but the repayment period typically lasts 10 – 20 years.
Other Land Purchasing Options
If you’re interested in purchasing land but are wary of taking out a land loan, consider these other options that might end up being a more suitable choice for your needs.
Home Equity Loan
Home equity loans are different from land loans and may be a more desirable option for some borrowers. They don’t require a down payment, and they can usually lock in a lower interest rate regardless of what you plan to do with the land because your home secures the loan. In addition, the interest you pay is not tax-deductible because you’re not using the loan to buy, build or improve the home used as collateral. The loan repayment term can vary depending on the lender but could last 5 – 30 years. Unfortunately, if you default on the loan, you could lose your home. Rocket Mortgage®does not currently offer home equity loans.
Seller financing can also be a desirable option for some borrowers. This is a real estate agreement where the seller handles the mortgage process instead of a financial institution or lender. Instead of applying for a traditional mortgage, the buyer signs a mortgage from the seller. This option can be beneficial for buyers because sellers tend to be more flexible than financial institutions.
The Bottom Line
If you’d like to build a home, be sure to weigh the benefits and drawbacks of a land loan to see if it’s right for you. While the thought of building your dream home sounds perfect, it’s important to be aware of the realities that come with taking out a land loan. Luckily, if you’re not interested in obtaining a land loan, there are other options for you. Although Rocket Mortgage® does not offer land loans, you can learn more about various loan types for all of your needs in the Rocket Mortgage® Learning Center.
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