Your Guide To Getting a Land Loan
The days of land loan's used to be as simple as walking into your local bankers office and sharing your ideas for why you wanted a land loan. Today, it would be unusual for your banker to know you and for you to know your banker. Bankers and lenders are no longer on a first name basis but rather an as needed basis. And let's face it, that makes it more difficult to get the loan that you want or need.
As if that wasn't enough, whether you're buying land for agriculture, perhaps a vacant lot to build on, or land for recreational purposes, land loans can be more difficult to get than other traditional loans such as home loans and mortgages, even if you have good credit. This article is going to share with you why that is and what you can do to make it more likely you'll receive a stamp of approval.
Why It's More Difficult to Get a Land Loan
It's more difficult to get a land loan because land is just land. What is meant by that, is it doesn't have the ability to produce income outside of renting it out for agricultural purposes. If renting it out for agriculture is your plan, you'll need a decent down payment before the bank gives you a loan. By decent, probably around 20 to 50% depending on the circumstances.
Another reason land loans are difficult is that people are not as incentivized to pay their mortgage on a vacant piece of land as they would be a home that is their primary residence. The bank knows this part of human psychology and it creates a challenge to land lending.
Lastly, a land loan is what people in the industry call a "nonconforming" loan which simply means that the loan doesn't fall into the standards established by federal home lending organizations such as Freddie Mac and Fannie Mae. Therefore, banks are less likely to create land loans because the secondary market(where loan originators can sell their loans to ther lenders) for them is not as strong as that of "conforming" loans.
Regardless, a loan on land is not what banks prefer to originate or have on their books. But never fear, read on for solutions.
Differentiating Between a Lot and Undeveloped Land
Be aware that banks or lenders may differentiate between a lot with a road and utilities developed on it and large piece of undeveloped land. The latter being the more difficult one to obtain a loan on. A piece of undeveloped land not being used for agricultural purposes would likely fall into the category of speculative borrowing/lending.
It will be good to talk to your bank or lending instituion to gain an understanding of what they classify as vacant land or a lot. As mentioned above, vacant land may be more challenging to get financing for.
Qualifying Through a Bank
First, you'll want to make sure you have good credit. Trying to get a land loan with bad credit would be like your kid asking for candy when they've misbehaved...it isn't going to happen. Next, you'll need income or cash flow to cover your land loan interest payments. The bank won't just take your word for it so you'll have to share W-2's and bank statements so that they can understand your monthly income and expenses. The bank will be checking for an income to loan ratio they are comfortable with which will depend on the specific bank and your specific circumstances.
After you've shared your information and the initial boxes are checked off, they will need to examine your credit history. If your credit passes the test, and your bank is interested in the loan, they will need to get an appraisal done on the land you plan to purchase in order to make sure the value is close to what you are paying for the land. If the appraisal doesn't come back favorably, the bank may require a larger down payment.
Here are some other quick items to be aware of when financing your land loan through a bank:
- Loan Length - The loan term length may be shorter than a conventional home loan. Typically, it may be between a 10 and 15 year loan.
- Interest Rate - The interest rate may be higher than conventional home loans. For reasons stated above, land loans will typically require a higher interest rate.
- Collateral - You may need to provide more collateral to secure the loan. Collateral is something that you provide as a guarantee against the loan. In other words, if you default on the loan, the bank would own the piece of property you provided as collateral to the extent necessary to make the bank whole.
- Underwriting - You will likely be requireed to fill out more paperwork in order to get a land loan. This paperwork can range from additional surveys done on the land, to additional points and fees associated with loan origination.
Seller Financing
If bank land financing doesn't work, it might be a good idea to approach the seller to ask if they would finance the property themselves. If they agree, you'll have to negotiate the terms such as the interest rate, down payment, loan length etc., but this could be an attractive solution if the bank doesn't offer financing. It may be a win win for a motivated seller if they don't need the cash from the sale immediately. If the seller doesn't own the land free and clear, the ymay need to navigate their existing finance terms with their current lender in order to offer seller financing which may be a dead end negotiation.
This could be a great short term solution if you plan on building on or developing the land. Once you have built on the land, you could refinance through a bank since the seller financing would likely be a short term solution. Once the land is developed, the bank may be more likely to approve you for a loan, especially if it is now a conforming loan.
If seller financing is the route that you choose, there are easy to use loan agreement templates online. Just Google "how to draft a loan agreement."
Assuming the Loan
One more option could be to assume the landowners existing loan on the property. You'll need to work directly with the land owner's current lender to navigate the fine print required for you to do this.
Be aware that you'll also need to be able to purchase or pay for the land owner's equity that they have built up in the land unless their land value doesn't exceed their loan value. And in order for you to pay for the amount of equity they have in the land, you'll both need to agree what the land is worth as that will be the direct factor that calculates land equity.
If the seller originally financed the land at a favorable interest rate, and interest rates have risen considerably since, then assuming an existing loan with a great interest rate could be the best route. This interest rate advantage could also pose challenges to negotiating with the bank as they will want to create a new loan at the higher current interest rate.
Home Equity Loan
Taking a home equity loan could be another option. A home equity loan works where you remove cash equity from your current primary residence in order to pay for or make a down payment on the land. If you plan to build your primary residence on the land you're buying, it could make sense to cash out your equity and use that to buy the land your future home will be located on. After you finish building, you can sell your former home(if you choose) and move remaining monies or equity into a down payment on your newly built primary residence.
If you seek bank financing through the same lender that holds your current primary residence mortgage, they may just let you use your home equity as collateral against your new land loan rather than cashing out your home equity. This just becomes a matter of how you and your bank want to arrange the furniture so to speak.
401K Loan
Another option could be a 401K loan. It's hotly debated whether 401K loans should ever be used in any situation, but if you have a balance in your 401K, your employer may have a loan program where you can borrow money from your 401K. Borrowing programs differ from company to company but typically they are structured so that you can't remove your entire 401K balance. In addition, your 401K loan would have to be paid back with interest but the advantageous aspect is that the interest actually gets paid back into your 401K balance. Essentially, you will be paying yourself the interest. And the interest rate is usually very attractive relative to market interest rates.
Take note that 401K loan lengths are usually a max of 5 years so you'll need to be able to pay it back faster than other loans on average. Similar to seller financing, this could be a source of short term financing until your loan can become a conforming loan and qualify for refinancing through a bank.
Be aware that paying back a 401K loan is usually done through an automatic withdrawals from your paycheck. To gain a better understanding of how a 401K loan may work and to calculate your payments, use our 401k loan calculator.
Conclusion
It's important to be aware of the challenges of getting land loan financing. This may deter many from even trying, but if you are determined to buy land, there are unconventional methods to making your dream of owning land a reality.
IQ Calculators offers many online financial calculators with one of them being a land loan calculator. We encourage you to use this calculator when considering your next land purchase.