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How to Tap Land Equity

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So you bought yourself a nice house with a small lot and you didn’t think the mortgage process was too terribly difficult? Well, that may be because your small lot had a house sitting on it.

Trying to buy the same lot without the house likely would have been considerably more challenging. Just how much of a challenge can vary, depending on what type of land you’re buying, why you’re buying it and where it’s located. Your creditworthiness and whether you’ve bought land before will also come into play as you attempt to get a land loan.

When it comes to buying land, you’re likely to have to put a good chunk of money down, as well as accept shorter repayment terms and higher interest rates for the loan. Nonetheless, many people still find buying land an appealing option as a short- or long-term investment, a site for a home or business or a family legacy, among other motives. Also, as a bonus, the land can be used as collateral for land equity loans — although it’s not easy to get those loans, and they often don’t come with the best terms.

Why people own vacant land

The main reason people buy land is so they can build something on it — typically a home or business. And they’re in luck because while lenders aren’t always enthusiastic about issuing this type of loan, they are much more likely to do so if the potential owner plans to build on the land or otherwise improve it.

Borrowers might have to pay as much as 10% to 20% for a down payment on a lot loan, with repayment of up to 20 years. Yet borrowers are likely to have to put down as much as 50% for raw land with speculative value and repay over five to 10 years, with interest ranging from 6.24% to 9.99%.

“Banks are mostly concerned about repayment risk,” said Juan Saldana, associate director for the Small Business Development Center at the Little Village Chamber of Commerce in Chicago. He’s also a consultant for developers who put together real estate deals with municipalities.

“An improved asset a banking institution can resell at auction is a more attractive investment than unimproved land because, in a worse-case scenario, the bank can recover some of its capital,” he said.

People also buy land purely as an investment. That’s not surprising, given the fact that investing in land, despite the risks, can pay off big if you know what you’re doing.

Saldana agrees that land can be a smart investment, although he emphasizes that you need to be knowledgeable.

“If a city’s population is growing and the investor understands how to improve real estate, buying land with the plan to rezone it to a higher and better use can yield good returns,” he said.

Some land speculators might even take advantage of usage rights by leasing the land out for farming if the soil is right, or forestry if there are trees aplenty, or drilling or mining, Saldana said.

Buying land that can be used for such purposes could remove one of the major reservations some investors have about buying land — that the land might just sit there, year after year, without generating income. The tendency of land to lie fallow is one reason Saldana favors income property as an investment.

“If a person invests in income property, the income can create new capital,” Saldana said. “Land without improvements typically does not create new capital; it may increase in value, but that is illiquid.”

While it’s true that many lenders may be reluctant to extend loans for land purchases, these loans can still be found. Your best bet is likely to be a community bank or credit union because these institutions typically have more knowledge about local properties. The likelihood of getting a loan is higher if you’re in the market for a construction-ready lot and have definite plans to build.

Along those lines, if you’ve consulted with a construction company, there’s a good chance they can recommend a lender, Saldana said. Working with a mortgage broker could be helpful, as they will have access to a wider network. Various federal programs can help facilitate a land or construction loan, although some are narrow in scope, specializing in farms, rural properties or business construction (SBA (7a) and SBA 504 loans).

You may also be able to get a personal loan to buy land, or deal directly with the seller for financing.

How a land equity loan works

Whatever you plan to do with your land, it can be put to reasonably good financial use as collateral for a land equity loan. Most often used to finance construction of a home or building (or several), a land equity loan can also be used to make new investments or consolidate debt, or anything else that requires an infusion of cash.

For home equity loans, lenders are often willing to make loans for between 80% and 90% of the loan-to-value — the amount left on the first mortgage compared to the home’s market value. However, most lenders cap equity loans for vacant, unimproved land at 35% of loan-to-value — and double the five-year home equity interest rate to 7.75% to 11.5%.

Equity loans for improved land are likely to be more favorable, but nowhere near as favorable as the terms for home equity. Land equity loans can be fixed or variable, and offer a lump sum that can then be used as a down payment on the construction of a home or other building.

Pros and cons of a land equity loan

The biggest advantage of tapping land equity for a loan is that you can likely avoid putting your personal home at risk. Unfortunately, a land equity loan also comes with many drawbacks. The major downside, especially if the land remains raw or unimproved, is that lenders consider vacant land a serious risk. The same concerns that make it difficult to secure a loan to buy unimproved land apply here.

You’ll also probably experience frustration trying to get something like fair value for your land equity, given the reluctance of most lenders to issue a land loan for anything near the amount you might expect from a home equity loan. You are also likely to be stuck with a comparatively short-term repayment schedule and higher rates of interest. In fact, some lenders may not offer you a loan in any amount, on any terms, unless you own the land free and clear.

Nonetheless, a land equity loan can put the cash value in your land to constructive use with nothing at risk except an investment.

As with any other loan such as a home mortgage or business loan, the better your credit score, the healthier your debt-to-income ratio and the more money you have for a down payment, the better your chances of getting a loan, and one with favorable terms. And whether you can use your land as collateral will also depend on the appraised value of the land, the condition it’s in and what your plans are for it.

Bottom line

Land can be a risky investment, but it can also offer rewards. Borrowers should understand the pros and cons, as well as the terms of land loans, before jumping into such an investment. Land equity loans may be one way to put your investment to good financial use, including funding new construction or debt consolidation. Because of the higher-risk nature of this kind of investment, you may want to discuss it with a financial adviser or estate planning expert before making the plunge.


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