Land Loans vs Home Loans: Key Differences You Need To Know

Purchasing land to build a home from the ground up can be an exciting prospect for many buyers. However, financing raw land is different than getting a traditional mortgage. As you weigh your options, it’s important to understand the key differences between a land loan and a home loan.

What Is A Land Loan?

A land loan, also called a lot loan, is financing used to purchase a vacant plot of land. Land loans allow buyers to acquire property they intend to build on or use for other purposes in the future.

Since there is no existing structure on the land to use as collateral, lenders view land loans as riskier than mortgages. As a result, land loans typically have higher interest rates and require larger down payments compared to home loans.

Land Loan Types

There are three main categories of land loans:

• Raw land loans – For completely undeveloped land with no access to utilities or infrastructure.
• Unimproved land loans – For partially developed land with some utilities and amenities.
• Improved land loans – For land with access to utilities and other infrastructure.

Raw land loans carry the highest risk and therefore have the strictest approval requirements Improved land loans are the least risky option

How Do Land Loans Work?

The process of obtaining a land loan is similar to getting a mortgage

• The lender evaluates the borrower’s finances, credit history, and intended land use.
• If approved, the lender issues interest rates and loan terms based on perceived risk.
• The borrower makes a down payment and repays the loan in installments at the agreed upon interest rate.

Since land itself does not generate income, lenders require a substantial down payment – often 20% or more of the purchase price. Interest rates are typically 1-2% higher than mortgage rates.

Land loan terms tend to be shorter than home loans, often 5-10 years with a balloon payment. This gives the lender a faster way to recoup funds if the borrower defaults.

What Is A Home Loan?

A home loan, or mortgage, is financing used to purchase a property that has a residential structure on it The house itself serves as collateral for the loan, making mortgages lower risk than land loans.

Standard mortgage terms are 15 or 30 years. Down payments are usually 3-20% of the purchase price. Interest rates are lower compared to land loans, and depend on factors like the borrower’s credit score and debt-to-income ratio.

Mortgages are available through banks, credit unions, mortgage lenders and brokers. Government agencies like FHA, USDA, and VA also offer specialized mortgage programs.

Key Differences Between Land Loans And Mortgages

Collateral – Mortgages use the home as collateral. Land loans have no built structure to serve as collateral.

Risk level – Mortgages are lower risk for lenders. Land loans carry more risk.

Down payment – Mortgages may need 3-20% down. Land loans often require 20%+ down.

Interest rates – Mortgage rates are lower, starting around 2-6% currently. Land loan rates are typically 1-2% higher.

Loan term – Mortgages usually have 15/30 year terms. Land loans often have shorter 5-10 year terms.

Property insurance – Mortgages require home insurance. Land loans don’t need property coverage.

Closing costs – Mortgages have more third-party fees like appraisal and title insurance. Land loans have lower closing costs.

Pros And Cons Of Land Loans

Pros

• Build your ideal home from the ground up
• Tap into home equity by using land as collateral
• Potentially purchase land for less than a move-in ready home

Cons

• Higher interest rates and down payment requirements
• Shorter repayment terms
• No existing structures to lease or sell if needed
• Land can be difficult to resell quickly
• Unexpected construction delays are possible

Pros And Cons Of Home Loans

Pros

• Lower interest rates and down payments than land loans
• Longer 15 or 30 year repayment terms
• Purchase a move-in ready home
• Easier approval process than land loans

Cons

• Less flexibility to customize the property
• Potentially higher upfront purchase price
• Inherit previous owner’s decor and renovations
• No control over neighborhood construction

Which Loan Is Right For You?

If you want the flexibility to build a fully customized home, a land loan may be a good fit despite the higher costs and stricter requirements. Just be sure you have a solid construction plan and timeline.

For those who need a quicker move-in ready home, or don’t want to tackle a new construction project, a traditional mortgage is likely the better option. The lower rates and payments can make owning an existing house more affordable.

Carefully consider your goals, finances and the pros and cons when deciding between a land loan or mortgage. Connect with a lender to discuss rates and pre-approval for either type of loan.