A land loan can be one of the most affordable and achievable ways for first time buyers to build a house.
But, what’s a land loan?
With the cost of homes skyrocketing in the past year, more homebuyers have started to consider purchasing land to build a new home instead of buying an existing one. There’s a benefit to this tactic, because it can save buyers money in an inflated market. Buyers also get to choose the design and layout of their new home, an additional bonus.
As with most real estate endeavors, however, there’s more to purchasing land than it might seem at first. Before you decide to move forward with building your new home on a plot of land, it’s important to learn about your land loan options and how to maximize your chance of qualifying for one.
Land Loan vs. Construction Loan
A lot of similarities exist between land and construction loans. Lenders offer both for buyers who want to purchase property to build on.
Construction loans work best if you’re looking to build a home immediately after purchasing your land and you have a development strategy in place.
Land loans are better if you’re not yet sure what or when you want to build, and it’s possible you might not start your project for a few months or years.
If you determine a land loan is the right way to go, from there you’ll need to decide which type of land loan is best for you.
Three Types of Land Loans
1. Raw Land Loan
Raw land is probably what you think of first when you picture a plot of land in your mind. No sewers or electricity, likely not cleared, and not necessarily connected to nearby roads.
A person who applies for a raw land loan will have a more difficult time getting qualified compared to the other types of land loans. Why? Lenders see the purchase of raw land as a risk, because it requires a lot of planning and effort to develop the land and it’s more difficult to determine the value of land than an existing home. For that reason, lenders prefer to accept buyers with a higher downpayment (20%+) and an excellent credit score.
Raw land costs the least out of all types of properties, but clearing and development expenses, high interest rates, and the requirement for a higher downpayment can counter this to the degree that it’s no longer a financial benefit. It’s crucial to weigh the pros and cons of your options before making a decision.
2. Improved Land Loan
Improved land comes with already existing perks like electricity, water, sewer, and possibly even landscaping. You may find properties like these for sale in developing subdivisions. They come at a higher price than raw land, but lenders don’t consider improved land purchases to be as much of a risk. That means you won’t need to have such a high downpayment and your interest rate will be lower. You’ll also avoid the hefty cost of developing raw land.
It’s possible the financial benefit of purchasing improved land will outweigh the lower price of raw land. Again, the best decision varies from buyer to buyer, so make sure you weigh out all of your options before going one way or the other.
3. Unimproved Land Loan
Unimproved land lies halfway between raw and improved land. It might include some of the already existing development that comes with improved land, but not all. As you might expect, the cost falls between that of raw and improved land. In the same vein, lenders will require a smaller downpayment and offer lower interest rates than for raw land, but higher than for improved land.
How to Get a Land Loan
The process is not too different from applying for a mortgage loan.
Community banks and credit unions offer land loans, so if you would qualify for a conventional mortgage loan, this may be the best route for you.
You can also apply for a land loan through a government program like USDA. Designed for lower income families, USDA offers 0% downpayment options and low interest rates for buyers who are purchasing a home or land in a rural area.
In general, the higher your downpayment and better your credit score, the more likely your lender is to approve your land loan. If you can, aim for a 20% or higher downpayment and work on improving your credit score so it reaches the very good (740-799) to excellent (800-850) range.
Pros and Cons
When you obtain a land loan in order to build your home, you’ll benefit in several ways.
- The cost of purchasing land and building a new home may be less than that of buying an existing home.
- You can design and build your new home the way you want to.
- You won’t have to start construction right away if you need time to plan and develop a strategy.
However, you may be hindered by some downsides.
- You’ll encounter the expense and stress of needing to develop your land before you can start constructing your new home.
- The requirement for a higher downpayment and better credit score to qualify for a loan may be more than you can justify.
- Higher loan interest rates will make your monthly payments more expensive.