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Land loans: How they work and how to qualify

Yahoo Personal Finance· Getty Images
Updated 5 min read

While 87% of home buyers purchase previously owned homes, some want to build their dream home. For these buyers, the entire process may begin with a land loan. This kind of financing, also called a lot loan, can help a borrower afford a plot of land.

Land loans work much like traditional mortgage loans, but they tend to be more difficult to qualify for, have shorter repayment terms, and charge higher interest rates. Understanding how these loans work and what costs to expect can help you decide if a land loan is right for you.

Learn more: Buying a new construction home — Pros, cons, and how to finance it

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Just as a mortgage loan is a tool for financing a home purchase, a land loan is a way to finance a land purchase. Unlike a construction loan, which borrowers generally take when they want to buy a plot of land and immediately begin building on it, a land loan is more commonly used to purchase a piece of land for a future building project.

The property secures a land loan in the same way that a home secures a mortgage. If you default on a land loan, your lender can seize the plot of land to recoup their losses. However, land loans are considered riskier for lenders than traditional mortgage loans because a borrower who defaults only loses the land rather than losing their home. That means borrowers may be less likely to prioritize monthly land loan payments over rent, mortgage, or car payments.

This additional risk to lenders is why land loans tend to have stricter borrower requirements than traditional mortgages.

Dig deeper: Is it better to build or buy a house?

The type of land loan you get will depend on the kind of lot you are interested in purchasing. These are the most common land loan types:

This type of loan is for undeveloped land with no sewer, water, electricity, or road access. Due to the amount of work needed to make a new home livable on such land, raw land loans have higher down payment requirements and tend to charge higher interest rates.

An unimproved land loan is for a lot that doesn’t have all the amenities needed for building a house but does have some developments, such as road access and electricity. This kind of loan can have a lower down payment requirement and lower rates than a raw land loan, but it is still more expensive than many other types of home loans.

Fully developed plots with all the necessary amenities for building a new home would qualify for an improved land loan. You will commonly find this kind of land sold by a developer in a ready-to-build subdivision. Since the land has been fully developed, this kind of land is generally more expensive than raw or unimproved land — but an improved land loan has lower interest rates and down payment requirements.

Read more: Types of mortgage loans

Though specific borrower requirements can vary greatly depending on your lender, these are some of the most common requirements:

  • Down payment: The FDIC requires a minimum down payment of 15% to 35% of the value of the land, depending on the type of land being purchased, with raw land loans requiring the highest down payments. However, some lenders may require up to a 50% down payment.

  • Credit score: Most lenders require a minimum credit score of 700 or higher to be eligible for a land loan.

  • Debt-to-income ratio (DTI): Borrowers generally need a DTI of 43% or lower to qualify.

In addition to these requirements, most lenders will also need to see proof of consistent income and that you have a plan in place for developing the land. Without either of these, you may have trouble getting approved for the land loan, even if you otherwise meet the lending requirements.

Land loans tend to be more expensive than traditional mortgage loans. To start, it’s not uncommon for raw land loan interest rates to be at least 2% higher than mortgage rates. If mortgage rates are averaging 6.75%, raw land loan borrowers should be prepared to pay 8.75% or more. While unimproved and improved land loans may offer lower rates than raw land loans, borrowers should still expect higher rates than they would find with traditional mortgage loans.

Additionally, most land loans only offer two repayment terms: a fixed-rate loan lasting between two and 30 years or a balloon loan. With the balloon loan, you will have a low monthly payment for a short period and have to repay the entire remaining balance in one lump sum once the low repayment period is up.

Generally, borrowers will have an easier time finding a land loan through a community bank or credit union than through a large national mortgage lender. However, some well-known banks offer lot loans, such as Fifth Third Bank.

Though both types of loans allow you to finance the purchase of property, there are some essential differences between a land loan and a mortgage. For example, land loans have higher down payment and stricter borrower eligibility requirements than mortgages. In addition, land loans tend to charge steeper interest rates and offer fewer repayment term options.

Land loan terms are usually pretty short. The repayment term for a lot loan can be as short as two years or as long as 30 (though a 30-year term isn’t super common).

This article was edited by Laura Grace Tarpley