Land Loans: Everything You Need To Know

*As of July 6, 2020, Rocket Mortgage® is no longer accepting USDA loan applications.

Sometimes when potential home buyers are looking to buy a house, they start to consider building one instead.Before going down this road, borrowers should determine what it might cost to build a house and buy the land to build it on. 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 choose to build a house, chances are you’ll apply for a land loan. While Rocket Mortgage® doesn’t offer land loans or lot loans, we understand the importance of providing real estate insight and know-how, and we can help point you in the right direction to find the right lot for your new home.

A land loan – sometimes referred to as a lot loan – is used to finance the purchase of a plot of land. You can take out a land loan if you’re interested in buying a piece of land to build a home or use for business purposes. The type of loan you take out will depend on where you’re buying land and how you intend to use the land.

A land loan is sometimes confused with a construction loan, which is another type of loan often used by people looking to build a house. So, what’s the difference? Typically, if you want to buy land and start building on it right away, you get a construction loan. These short-term loans are intended for prospective home builders who want to start on their construction project right away and have everything planned and ready to go.

Land or lot loans, on the other hand, are a better choice for future home builders who have a plan but may not want to jump right into building and financing a house. If you have circumstances pushing your building project out a year or so (or you’re still getting your home plans together) a land loan is likely a better choice for you.

While Rocket Mortgage doesn’t offer land or construction loans, you can still qualify for a mortgage on a new-construction house. We can also help you refinance an existing construction loan into a traditional mortgage onceyour new home is built. The home must be finished and have a Certificate of Occupancy.

The three most common land loans are raw land loans, unimproved land loans and improved land loans.

Raw Land Loan

Raw land refers to a completely undeveloped area with no electricity, sewers or roads. 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 a great risk.

You can also increase your chances of qualifying if you make a large down payment (typically 20% or more) and have good credit. While the purchase price of raw land can be cheaper than developed land, raw land loans have higher interest rates and require larger down payments than other land loans.

Unimproved Land Loan

Unimproved land is similar to raw land, but it tends to be more developed. Sometimes unimproved land has some utilities and amenities, but it 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 be difficult to get. To improve your chances,make sure you have a detailed plan, a large down payment (20% down or more) and a strong credit score. Because unimproved land loans aren’t the riskiest loan type, the down payment requirements 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, the interest rates and down payments for improved land loans are lower than raw land loans or unimproved land loans. Nonetheless, you still need to make a significant down payment and have a good credit score.

A borrower obtains a land or lot loan the same way a home buyer obtains a mortgage loan. However, 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. Let’s explore how to buy land to build a house.

Loan Qualifications

Each land loan type has qualifications borrowers must meet. However, there are still general requirements borrowers must meet to apply for a land loan:

• Have an excellent credit score (720 or higher)
• Explain the intended use of the land
• Highlight necessary property checks, like zoning, land-use restrictions, surveyed boundaries and access to utilities

Once a lender considers these factors, the rates and obligations of the land loan can be issued. Land loan interest rates tend to be higher than mortgage interest rates because they’re riskier. However, a borrower can qualify for lower rates if they have a better credit score and a low debt-to-income ratio (DTI).

Lending Process

After the loan’s rates are determined and the borrower is approved, the borrower must make a down payment and paythe loan back in installments for the determined interest rate.

Once the construction of your new house is complete, you can refinance your land loan into a traditional mortgage. Refinancing can help you secure a new principal balance and lower interest rate. To refinance to a traditional loan with Rocket Mortgage, construction must be fully completed and you must have a Certificate of Occupancy.

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 pros and cons and see how they’d apply to your needs and financial situation.

Pros

If building a home or business is important to you, applying for a land loan offers many benefits. The biggest benefit by far is the opportunity to build the home of your dreams. If you want to use the land for commercial purposes, it offers 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 can be the perfect option for you.

Cons

It’s important to understand the realities and drawbacks of applying for a land loan. For example, when there isn’t a house to use as collateral, a land loan can be riskier for lenders, which makes many lenders less willing to lend money. When it comes to financing, there is also the potential for a higher down payment requirement and higher interest rates.

Because it’s a new construction, there’s always the possibility of dealing with unforeseen complications, for example building supply shortages. For some buyers, a traditional mortgage may be a better option that offers a smoother buying experience.

It’s typically easiest to get a land loan from a community bank or credit union located near the land you’re looking to buy. But depending on your intention for the land, there may be other loan options available.

Primary Residences

If you’re planning to build a primary residence in a rural area, you can apply for a U.S. Department of Agriculture (USDA) loan. USDA loans and USDA construction loans are intended for low- to moderate-income families. They have low interest rates, and depending on the situation, borrowers may qualify for a lot loan with no down payment.

Commercial Properties

If you’d like to use a land loan for commercial purposes, you can apply for an SBA 504 loan. SBA loans are provided by the Small Business Administration (SBA) and are intended for business owners who need funds to purchase land. The interest rates and terms of SBA loans can vary, but the repayment period typically lasts 10 – 25 years

If you’re interested in purchasing land but are wary of taking out a land loan, consider these other options that may be more suitable for your needs.

Home Equity Loan

Home equity loans act as a second mortgage and allow you to use some of the equity you’ve built in your existing home. A home equity loan doesn't require a down payment, and you can usually lock in a lower interest rate regardless of your plans for the land because your home secures the loan. In addition, the interest you pay isn’t 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 can last 5 – 30 years. Unfortunately, if you default on the loan, you may lose your primary home.

Rocket Mortgage is now offering The Home Equity Loan, which is available for primary and secondary homes.

Seller Financing

Seller financing can be a desirable option for some borrowers. Seller-financed land agreements are sometimes called land contracts. They are real estate agreements where the seller acts as a lender and directly handles the mortgage process. Instead of applying for a traditional mortgage, a buyer signs a contract with a seller.

This option can be beneficial for buyers because sellers tend to be more flexible than financial institutions, which means it may be easier to qualify for a seller-financed loan than a traditional loan. Seller financing can be useful for aspiring land buyers who are struggling to qualify for a land loan or afford a large down payment.

However, legal homeownership can be a bit of a gray area when paying for a seller-financed property. While you receive an equitable title, your seller retains the legal title of the property until you pay off the loan, which can cause problems. Additionally, your seller may charge you higher interest rates and the terms of your contract may be vague.

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 may sound perfect, there are other options available.

If you want to design from the ground up, a land loan may be the best choice for you. You can get started by exploring open lots in your area to find the perfect spot to build.

Rocket Mortgage doesn’t offer land loans, but we may be able to help you refinance an existing land or construction loan to a traditional mortgage on your newly built house. Start your application today.