Buying land to build a house on? What to know about property loans

Most homebuyers look at existing homes for sale and purchase one they like. But some buyers would rather buy land and build their dream home on it. If this appeals to you, you may need a property loan to make it happen.

If you’re not sure what property loans are, or whether you should get one, this guide will cover what you need to know so you can decide if this option is right for you.

• What are property loans?
• How do property loans work?
• How big of a loan can you get?
• Property loan financing options
• Property loan pros and cons

What are property loans?

Property loans — also known as land loans or lot loans — are used to finance the purchase of a plot of land. Banks typically issue these loans to borrowers who want to build a home or use the land for business purposes.

The type of loan you need depends on the type of land you’re buying. You can choose from three types of property loans:

• Raw land loan — Raw land is completely undeveloped, with no utilities or roads. Raw land is usually cheaper than other types of property loans, but getting financing can be challenging.
• Unimproved land loan — Unimproved land may be partially developed and have some utilities or older structures, but it usually doesn’t have electric or gas meters or a phone box. It may be easier to get financing for unimproved land than raw land, but you’ll still likely need a large down payment and a strong credit score.
• Improved land loan — Improved land has access to roads and is fully functional. Because it’s the most ready to build on, it’s also the most expensive and the easiest to finance.

How do property loans work?

If you have enough money in your savings account, you may be able to purchase the land you want with cash. Otherwise, you can apply for a property loan.

The different financing options to help you purchase land each come with their own qualifying criteria. But some guidelines apply across the board: You’ll generally need excellent credit and a down payment between 15% and 35% of the purchase price or higher.

The Federal Deposit Insurance Corporation (FDIC) sets minimum down payment requirements for property loans, although some lenders can opt for higher down payments (up to 50%). The FDIC’s down payment requirements are:

• Raw land — 35% minimum down payment
• Unimproved land — 25% minimum down payment
• Improved land — 15% minimum down payment

Because it can be expensive and complicated to develop land, lenders charge higher interest rates on property loans than traditional mortgage loans to mitigate their risk. Repayment terms for property loans can be much shorter than standard 15- and 30-year conventional mortgages, as lenders seek to recoup their investment faster than for conventional home loans. But if you plan on building a home on the property, you may be able to get a longer loan term.

While the terms and interest rates for land loans are different from mortgage loans, the loan process is similar. You’ll need to provide financial documents, such as pay stubs and account statements, and the lender will review your credit report. As part of its underwriting process, the lender may ask you to provide information on how you intend to use the land.

Like a mortgage, if you’re approved for a property loan, you’ll be obligated to repay the balance with interest. But unlike mortgage loans, many property loans are often set up as "balloon mortgages." This means you’ll make low or no monthly payments, or pay only the interest for a specified time, before making one large balloon payment to repay the loan in full.

How big of a loan can you get?

The amount you can borrow with a property loan varies depending on the lender and the type of land you buy. For example, a lender may approve a loan that funds 85% of the purchase price for improved land or it may offer to finance 65% of the cost for raw land.

Like conventional mortgage loans, how much you can get for a land loan depends on your income, debt-to-income ratio, down payment amount, and other factors.

Property loan financing options

When you’re ready to purchase a property, you have plenty of financing options at your disposal, including:

Lender property loan

Not many large national banks offer property loans, but many community banks and credit unions do. You can often obtain financing from a local lender in the same area as your land. With knowledge of the area, a local lender is in a better position to evaluate the value and possibilities for the land.

Seller financing

With seller financing, the seller offers you a loan rather than a bank or mortgage lender. You then submit your payment to the seller each month. The only money you’ll have to pay at closing is the amount you agreed upon for a down payment.

USDA Rural Housing site loan

USDA Rural Housing site loans provide financing for low- and moderate-income families looking to build a home on land in an eligible rural area. USDA loans are often easier to obtain than conventional loans. These government-backed loans have a two-year repayment term.

SBA 504 loan

If you’re buying land to use for a business, you may qualify for a 504 loan offered through the Small Business Administration (SBA). The 504 program offers long-term, fixed-rate loans of up to $5 million for projects that generate business growth and new jobs. The loans can be used for multiple purposes, including the purchase and construction of new facilities.

Home equity loan

If you already own a home and have significant equity in it, you may qualify for a home equity loan. In this case, you’ll get a lump sum of money upfront, which you’ll repay over time. It doesn’t matter what you do with the money, and you won’t have to pay a down payment. Additionally, you can usually secure a lower interest rate than you would with a property loan. But if you default on the loan, you risk losing your home.

Property loan pros and cons

As with any financial decision, it’s always wise to think about the benefits and drawbacks. Consider these pros and cons to see if a property loan makes sense for you:

Pros

• You can build your dream home exactly the way you want it. You also have the flexibility to hold the land and build only when you’re ready.
• You can take advantage of an up-and-coming area. Purchase the land now for future construction in an area with rising property values.
• You can use the land for business purposes. Establish a new location for your business.

Cons

• Obtaining financing may be challenging. Not all lenders offer property loans, and the ones that do often have stringent lending requirements and high interest rates.
• You may have to pay more. Since property loans aren’t backed by collateral, many lenders offset the risk by requiring a large down payment and charging high interest rates.
• Land may not be build-ready. If you’re buying raw or unimproved land, make sure you can get the utilities and improvements the lot needs to support a home in the future.