The Differences Between Lot & Land Loans

The American dream of home ownership usually involves applying for, and being approved for, a home mortgage loan. The process is relatively simple and repeated many times every day in the United States. A consumer decides to buy a home, finds one that they like, applies for a home mortgage and, when approved, purchases that home.

But what happens when a consumer wants to build a home, or have a home built for them from scratch? What if that same consumer finds a wonderful piece of land or an empty lot in a subdivision, and decides that they want to purchase that lot or land and build their home on it?

In this situation, the consumer will need a loan that's significantly different in several ways from a typical home mortgage. In fact, a lot and/or land loan is referred to as a "nonconforming" loan, because it doesn't conform to the guidelines for mortgages that were established and standardized by both Fannie Mae and Freddie Mac.

Are land and lot loans really that much different from traditional mortgage loans?

Yes, they are. Fannie Mae and Freddie Mac were created to give specific criteria about home mortgage loans, including how they need to be secured by a property that already has a completed house sitting on it. Without a completed home as collateral, things change significantly.

One of the reasons is that a nonconforming loan isn't nearly as "liquid" as originating lenders prefer. This type of loan can't be sold as easily in a loan portfolio using the secondary market, something that can easily be done with a purchase money loan.

It's for this reason that lenders and banks look at land and lot loans less favorably. Another reason is simply because the risk they face of default or foreclosure is much higher with a nonconforming loan.

The way lenders look at it is that as the owner of a vacant lot or piece of land with no home sitting on it, a consumer doesn't have the same incentive to repay that loan as they would if they had a home to lose as well. Specifically when it is a home that is being used as someone's primary residence, as a borrower would be much less likely to default if it meant that they would be forced out of their only home.

What it boils down to is collateral, and the fact that an empty lot or vacant piece of land is less valuable as collateral then an existing home.

Banks actually don't want to foreclose on any type of loans

The rash of foreclosures in the last few years notwithstanding, the fact is that the typical bank and/or lender is not really keen on foreclosures. The reason is simply that banks don't make money managing real estate, they make money lending money. Foreclosure on a home, for a bank or lender, is thus an unattractive end to a mortgage loan.

That being said, when they’re forced to foreclose on a home loan, they already have systems and processes in place to manage and liquidate these homes. When it comes to land and lots, this isn't the case, making foreclosure on these types of loans even more unattractive.

What is the difference between a piece of land loan and a lot?

Most consumers don't realize that there is a very big difference between a piece of land and a lot, including the terms and conditions needed to have a loan approved for one or the other.

First it's important to understand that, unlike a traditional purchase money loan, a lot loan or land loan is more difficult to acquire, it comes with higher interest rates, and typically has higher requirements for approval.

The difference between the two pieces of land is also significant. For example, where a lot is typically located in a subdivision or development, a piece of land can sometimes be completely removed from any type of upgrades or improvements.

These improvements could include sewer systems, utilities like electricity, streets and sidewalks and so forth. In almost all cases a lot will also already have been zoned for construction, and any easements will already have been granted.

With a piece of land, it's quite possible that none of those upgrades or improvements have been done. It's also possible that zoning won't be permitted, and easements won't be granted. This would increase the chance that a borrower walks away from their land loan, more than someone who borrows for a lot.

What are the different terms that you will find for land and lot loans?

From a borrower's perspective, there are quite a few differences between a loan for a piece of land or a lot and a typical mortgage loan.

First and foremost, finding a bank or lender to approve a land or lot loan is more difficult because they’re nonconforming loans.

The length of a land or lot loan is usually much shorter as well. It's highly unlikely that you will find a 30 year land or lot loan, and in some cases, your payoff date might be as little as a few years or even a few months.

Monthly payments for a land or lot loan will usually be higher because the amortization period is much shorter.

The interest rates that are typically given for land and lot loans are higher as well, although you will find that some lenders will allow interest-only payments.

One of the biggest differences is collateral. When you apply for a mortgage loan, the collateral is the home that you're going to purchase. For a lot or land loan, a lender or bank might require you to have a substantial amount of money deposited in the bank, or “cross-collateralize” your loan with other assets and real estate that you already own.

While it's not impossible to get approved for a land or a lot loan, it is quite a bit more difficult to be approved for one. It will cost you more money in interest, and will usually need to be paid back in a shorter period of time.