Up for the quarter, down for the year? See what's happening with home affordability in our latest "Income you need to buy a home in the top 50 metro areas".

Up for the quarter, down for the year? See what's happening with home affordability in our latest "Income you need to buy a home in the top 50 metro areas".

How Do Lot Loans Work?

vacantWhat is a lot loan? Lot loans are mortgages secured by land. Lot loans work similarly to mortgages for homes, but there are important differences. This article explains how lot loans work and how to finance a land purchase.

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Difference between raw land and lot land

Not all land is technically a "lot." Raw land is just land, and it may not be suitable for development. Lot land is prepared for residential development. These features are typical:

  • A building permit or at least appropriate zoning
  • A survey and stakes indicating the site's boundaries
  • Access across public roads or an easement to gain such access
  • Utilities on-site or nearby
  • Access to a public sewer or a septic system

Lot loans are much easier to come by than financing for raw land for raw land. If you want to purchase raw land, many lenders consider that a commercial venture. You'll need a bigger down payment (up to 50%) and you'll probably pay a higher interest rate.

3 mortgages for one property?

When you purchase a lot and plan to build, you could end up with three loans - the lot loan, a loan for home construction, and a final loan, called "permanent" or "take-out" financing that is a traditional mortgage.

The lot loan purchases the land. The construction loan pays off the lot loan and finances the construction. And the permanent loan pays off the construction loan.

Note that you can pay for the lot and construction with one loan if you plan to build right away. Or you might take out a single "one-time close" loan for to buy a lot, build a home and then finance it.

Related: Manufactured Housing Resources

"One-time close" mortgages vs separate loans

If you plan to build right away, you may be able to close faster and pay fewer fees with a single loan. The first stage covers the purchase of the lot and the construction of a home. Once the house is suitable for occupancy, the permanent loan replaces the lot / construction financing.

The advantage is that you only have to apply and close once. The fees should be lower because working with a single lender should streamline the processing.

The disadvantage is that you don't get to shop each stage of the borrowing and choose the best deal for your lot, construction and permanent financing. The packaged deal offered by lenders might not be flexible enough or give you the time you want for each separate stage of building.

Related: Buying New Construction

Options for lot financing

You may prefer to finance your lot with or without a mortgage. This does give you more flexibility. Here are a few alternatives.

Home equity

You can choose to purchase a lot by borrowing against your current residence. If you have enough home equity, you can borrow against it with a fixed home equity loan or a variable home equity line of credit (HELOC).

The fixed loan makes budgeting easier. However, setup costs are higher than they are for HELOCs. Fixed loans deliver a lump sum at closing, which you can use for your lot and construction. But you pay interest on the entire balance from Day One, so if you're not planning to build right away, this option may not be flexible enough for you.

The HELOC establishes a maximum amount that you can borrow at will. So you can purchase your lot and then tap the line later for construction costs. Interest rates are nearly always variable, though, so your costs are less predictable.

Personal loan

Personal loans are unsecured, so they are not mortgages. You can usually get them quickly because no one needs to appraise the property. Lenders set maximums as high as $100,000, and if your credit is excellent, interest rates can be nearly as low as those of home equity loans.

Maximum loan terms are about ten years. You can finance the lot and construction with a personal loan or line of credit. In that case, your permanent financing would be considered a cash-out refinance because you would not be paying off loans secured by property.

Seller financing

If the current owner of the lot is motivated, he or she might lend you the purchase price. You have a better chance of making a deal if you can show the seller that you're pre-approved for construction or construction-to-permanent financing, so the seller will get the money back fairly soon.

Seller financing is normally a mortgage secured by land. Your seller might draft an agreement entirely or use forms from an office supply store.

Fannie Mae and Freddie Mac (conforming loans)

Fannie and Freddie Mac offer construction-to-permanent financing (either construction conversion for an existing construction loan or one-time-close for new transactions) for based on the property acquisition cost or appraised value.

Borrowers and property must be eligible under program guidelines. While Fannie Mae and Freddie Mac loans are widely available, construction-to-permanent financing is harder to find. Not all lenders and loan officers offer it.

FHA 203(k) rehab mortgage

FHA 203(k) rehab mortgages finance the construction and / or rehab on a lot if there was previously a house there.

The U.S. Department of Housing and Urban Development says, "A home that has been demolished or will be razed as part of rehabilitation is eligible, for example, provided that the existing foundation system remains in place."

USDA loans

The United States Department of Agriculture and Rural Development finances construction in rural areas for those with modest. You can check your eligibility on the USDA's website.

Per the USDA, "Funds can be used to build, repair, renovate or relocate a home, or to purchase and prepare sites, including providing water and sewage facilities."

VA loans

If qualify, you may be able to finance your lot purchase and construction within a single loan and no down payment.

However, it can be difficult to find lenders and contractors who work with this program.

Local lenders

For lot loans, many times the best deal is local. Your community banks, mortgage companies and brokers have a good understanding of the local market and may be more committed to lending on local properties.

Typical rates and terms for lot loans

If you're expecting a mortgage with 5% down and a 30-year term for a lot, you'll be disappointed. Most lot loan programs require 10% or more down and the term maxes out at about 20 years. Expect to pay a higher interest rate as well. That's because lots are riskier to finance and lenders want compensation for taking on that risk.

In general, for a 10-year loan, your rate is about .5% higher than that of a traditional mortgage. Expect to pay .75% more for a 15-year term and 1% higher for a 20-year term.

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