When you are purchasing a home, you will likely need a loan to help you with the transaction. The type of loan you seek out will depend on the type of purchase you are making. If you are buying a standard home, you will need a mortgage loan. If you are buying an empty plot with intention to build a home, on the other hand, you will need a land loan. The two loans have different forms for their separate functions.
The first distinction between land loans and mortgages is their purpose; this sets the stage for all of the other distinctions. A land loan is issued so a borrower can buy a piece of land and prepare it for development. It may cover some construction costs of the home, but it is more likely to only cover the cost of turning a raw piece of land into a plot for a home. A mortgage, on the other hand, is used to purchase a home in its current state.
Both land loans and mortgages are secured with collateral. In general, a piece of raw land is worth less than the same piece of land with a home already on it. As a result, the collateral for a land loan is worth less than the collateral for a mortgage. This means the limit for a land loan is typically lower. Furthermore, since it is harder to assess the value of a land loan, the borrower will tend to receive a lower loan-to-value ratio on the property. This means, in addition to having a less valuable piece of collateral to start with, a borrower will also receive a smaller loan proportionate to the asset when using a land loan.
Most land loans are transitional. They are used to buy the land for a home and begin the building process. The goal is to then take out a mortgage once the home has been built. In doing so, the borrower can replace the relatively small, unfavorable land loan with a larger, more traditional mortgage. Land loans are often called "bridge loans" for this reason; they are not designed to be permanent in most cases.
Anytime you take a loan with a low loan-to-value ratio, you are engaging in a risky loan. For example, if you take a land loan for $200,000 to develop a plot of land worth $500,000, you could lose $300,000 of value if you default on the loan. For this reason, land loans tend to be much riskier for borrowers than traditional mortgages. A traditional mortgage is usually extended at 80 to 90 percent loan to value, meaning the borrower puts up 10 to 20 percent. If you default on that loan, you stand to lose much less.
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