What Is A Land Loan And Should You Use One?

For many aspiring homeowners, the prospect of purchasing a piece of land and building a home holds an irresistible allure. This path offers a unique opportunity to create a living space that's tailored to their specific needs and preferences. While the conventional route of applying for a mortgage to buy an existing home remains popular, buying land to build a home offers distinct advantages that resonate with a particular segment of borrowers.

Although Rocket Mortgage^® doesn’t currently offer land loans, this article will discuss the different types of land loans, how to navigate the application process and alternative financing options.

What Is A Land Loan?

A land loan is a type of financial product that is specifically designed to facilitate the purchase of vacant land or undeveloped property. Unlike traditional home mortgages, which are used to finance the purchase of a home or other structures, land loans focus on financing the acquisition of the land itself.

The types of loans available are designed to facilitate purchases and development of a wide range of land. The type of loan you choose depends on the land's purpose, current state and specific financial goals. These include raw land, unimproved land, improved land, rural land, commercial land, residential land and construction loans.

Land loans and construction loans are distinct types of loans used at different stages of property development. A land loan is focused on financing the purchase of vacant land, while a construction loan is used to fund the construction or renovation of a building on a property. In some cases, these two types of loans might be combined into a single package called a "construction-to-permanent" loan, which covers both the land purchase and the subsequent construction project.

Raw Land

Raw land, also known as vacant land or undeveloped land, refers to land that has not been improved, developed or built upon. It’s essentially an empty canvas with no structures or infrastructure present. Raw land can be found in both urban and rural areas, and it holds potential for various uses depending on its location, zoning regulations and other factors.

Unimproved Land

Unimproved land generally refers to land that lacks significant improvements or developments, but it may have undergone minor changes or alterations from its natural state. These alterations could include basic leveling, grading or clearing of vegetation. Some jurisdictions may consider unimproved land as land with minimal improvements or changes.

Unimproved land shares many key features with raw land, but there are subtle distinctions between the two. Unlike raw land, unimproved land may have minimal changes from its natural state but not any substantial structures or infrastructure.

Improved Land

Improved land refers to property that has undergone significant development and enhancements, making it suitable for specific uses or purposes. Improved land is characterized by its development, infrastructure and functional use, making it more suitable for specific purposes and often commanding a higher market value compared to raw or unimproved land. It offers opportunities for income generation, investment and immediate use, making it an attractive option for buyers and investors in various real estate markets.

How Do Land Loans Work?

As with a mortgage loan on a home, land and lot loans can be obtained in the same manner as a loan on a house; however, since there is no collateral attached to the property, it can be harder to determine what the land is worth.

Each type of land loan has its own criteria for applicants. However, there are still some general guidelines to be followed when applying for a land loan:

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

Taking these factors into account, a lender can determine the loan rates and obligations. As a result, land loan interest rates tend to be higher than mortgage interest rates. The debt-to-income ratio and credit score of a borrower can determine if he or she qualifies for lower rates.

Where Can You Get A Loan For A Land Purchase?

You can obtain a loan for land purchase from various financial institutions, including banks, credit unions, specialized lenders and online lenders. Here are some common options where you can research land loans:

• Private lenders: Local and national banks, as well as credit unions, often offer land loans. They may have specific loan products designed for different types of land purchases. There are lenders that specialize in providing loans for land purchases. These lenders may have more flexible terms and expertise in land-related financing.
• Small business lenders: Business owners can utilize the Small Business Administration (SBA) 504 loan program for certain real estate purchases, including land acquisition, but there are specific conditions and limitations. The SBA 504 loan program is designed to help small businesses acquire fixed assets for expansion and modernization. It typically involves two loans: one from a Certified Development Company (CDC) and another from a private lender.
• Farm Credit institutions: In rural areas, Farm Credit institutions are known for providing loans for agricultural land purchases. They often have tailored loan products for farming and rural property.

Should You Use A Land Loan?

A land loan offers a gateway to property ownership with distinct advantages and considerations. On the positive side, this specialized loan allows you to secure a piece of land for future development, whether it's building your dream home, embarking on a commercial venture or establishing an investment. The flexibility to choose your preferred location and customize your project to match your vision is a compelling advantage, especially with the potential for the land value to appreciate over time. However, the downsides include higher interest rates and substantial down payments, making upfront costs significant. Additionally, shorter loan terms may lead to higher monthly payments. The limited availability of lenders who offer land loans can pose challenges in finding the right fit. Ultimately, the choice of a land loan hinges on your financial goals, risk tolerance and vision for the property's future.

Alternative Forms Of Land Financing

If you're considering acquiring land for a specific purpose but are hesitant about taking out a traditional land loan, there are several alternatives and creative approaches you can explore depending on your financial situation, goals and the specific circumstances of the land purchase. Rocket Mortgage doesn’t currently offer construction loans.

Construction Loans

Securing a construction loan that isn't government-backed provides a tailored financial solution for those undertaking building projects. These loans are designed to fund the construction or renovation of a property and are typically offered by private lenders or traditional financial institutions. A construction loan works in stages, where funds are disbursed incrementally as different construction milestones are reached. Common stages include foundation, framing and completion. Borrowers typically need to provide detailed project plans, cost estimates, and may even require the involvement of builders and contractors. Lenders assess the borrower's creditworthiness, income stability and the value of the proposed property to determine eligibility.

USDA Construction Loans

USDA construction loans, including the Section 502 and Section 504 loans, are specialized financing options offered by the United States Department of Agriculture (USDA) to support the construction, repair or improvement of homes in eligible rural areas. The Section 502 Guaranteed Loan Program is designed for low-income individuals, while the Section 504 Home Repair Program serves individuals who are age 62 or older and are unable to secure credit elsewhere. These loans provide favorable terms and low-interest rates to make homeownership achievable in rural communities.

For both programs, the minimum required credit score is typically around 640, and the maximum allowable debt-to-income ratio (DTI) is approximately 41%. These USDA construction loans are valuable resources for those seeking to build or enhance homes in rural regions while benefiting from the support of a government-backed program.

FHA Construction Loans

To obtain an FHA construction loan from the Federal Housing Administration (FHA), applicants typically need a credit score of around 580 or higher, although higher scores can lead to better terms. A down payment of at least 3.5% is required, and borrowers must have a steady source of income, as well as proof of employment and income stability. Lenders also consider the borrower's DTI, which should generally not exceed 43%. The property itself must meet FHA guidelines and undergo an appraisal to assess its value and compliance with standards. With its lower credit score requirements and lower down payment, an FHA construction loan can be an accessible pathway for individuals looking to embark on a construction project or renovation.

VA Construction Loans

VA construction loans, supported by the Department of Veterans Affairs (VA), offer eligible veterans and service members the opportunity to build a new home or renovate an existing one. These loans provide several key features, including no down payment requirement for qualified borrowers, making them an attractive option for those who have served in the military. Additionally, VA construction loans typically have competitive interest rates, and borrowers benefit from the backing of the VA, which ensures favorable terms and reduced risk for lenders. The VA's strict property requirements aim to ensure that the constructed or renovated home meets quality and safety standards. This financing option empowers veterans to achieve their housing goals while enjoying the benefits of the VA's comprehensive support.

Home Equity Loans And HELOCs

With a home equity loan or a home equity line of credit (HELOC), homeowners are able to leverage their equity to purchase land and possibly build their dream homes. The owner of a home can receive a lump sum based on their equity. It is possible to use this lump sum to purchase land, whereas a HELOC is a revolving credit line homeowners can take advantage of as needed. The flexibility of this makes it appropriate for land purchases and construction expenses. Using the equity in their home, homeowners can convert their property into a financial resource to fund their envisioned development. While Rocket Mortgage doesn’t offer HELOCs, we do offer home equity loans.

Seller Financing

Seller financing offers an alternative route to land acquisition, providing an opportunity for buyers and sellers to create more flexible arrangements. In a land contract, also known as a contract for deed or installment sale agreement, the seller essentially acts as the lender, allowing the buyer to make payments directly to them over an agreed-upon period. This approach is particularly appealing to buyers who might not qualify for traditional loans or who seek more adaptable terms. The buyer gains ownership of the land while making regular payments, and the seller retains legal title until the contract is fulfilled. Land contracts can be customized to fit the specific needs of both parties, with terms negotiated around interest rates, repayment schedules, and other terms.

The Bottom Line

A land loan is a specialized financial tool designed for purchasing undeveloped land or vacant property. While different from traditional mortgages, land loans offer advantages such as ownership of a desired piece of land, customization opportunities and potential appreciation. However, they come with challenges like higher interest rates, larger down payments and shorter loan terms.

If you’re opting for a home equity loan or want to purchase a home instead of land, take the first step by submitting an application today.