Obtaining a loan to buy raw land (as opposed to land with a home or other buildings already on it) can be difficult. Even if you can find a lender willing to finance the purchase, the interest rate and fees may be significantly higher than on a regular mortgage. One alternative, if you own a home that has accumulated some equity, is to take out a home equity loan. But doing so has some serious risks. Here's what you need to know.
- You can use the proceeds from a home equity loan for whatever you want, including buying land.
- However, if you can't make the payments on your home equity loan, you could lose your home.
- Undeveloped land doesn't always increase in value, so it can be a risky investment.
- Using a home equity loan to buy land adjacent to your home could increase your home's value overall.
How To Use a Home Equity Loan to Buy Land
A home equity loan allows you to tap the equity you've built in your home, typically at a relatively low interest rate. The danger is that because the loan uses your home as collateral, you could lose it if you can't keep up with the payments.
To qualify for a home equity loan to buy land (or for any other purpose) you will need to have a decent debt-to-income ratio, a good credit score, proof of income sufficient to pay off the loan, and at least 10%, 15%, or 20% equity in your home, depending on the lender.
You can calculate the equity in your home by subtracting the amount you still owe on it from its current estimated value. For example, if your home could sell for $500,000 today and you have $200,000 in mortgage debt, your equity is $300,000. To translate that into percentage terms, divide your equity by the current value of your home. In this case, $300,000 divided by $500,000 is 0.6, or 60%—more than enough to qualify for a home equity loan.
Lenders usually won't let you borrow 100% of your equity, however. In a common scenario, the maximum might be 80% of your home's value, minus your mortgage debt. So, in the example above, the homeowner might be able to borrow as much as $200,000 ($500,000 times 80% equals $400,000. $400,000 minus $200,000 equals $200,000).
Special Considerations for Using a Home Equity Loan To Buy Land
Once you have qualified for a home equity loan and received the loan's proceeds, you can spend the money however you'd like. If you're buying land, it's a good idea not to spend it all on the property but to keep enough money in reserve to cover the property taxes, maintenance costs, and any improvements you need to make. Unless the land is producing income in some other way, you'll need to cover all of those expenses yourself and they can add up.
If it's your intention to build a home for yourself on the land, a construction loan might be another alternative. A construction loan is a short-term loan that ends once construction is completed. At that point, you will have a home that is eligible for a regular mortgage.
If the land you're purchasing is adjacent to your existing property, using a home equity loan could be a good financial and practical choice. Owning an extra parcel adjacent to yours gives you more options to do things like putting on an addition (or a separate dwelling) for your grown children or aging parents, or constructing an outbuilding for working remotely or seeing clients. Expanding your lot size should also increase your home's market value when the time comes to sell.
As an added benefit, you may be eligible for a tax deduction for your interest payments, depending on exactly how you spend the money. While the Tax Cuts and Jobs Act of 2017 suspended the deduction for interest on home equity loans and lines of credit from 2018 to 2026, it made an exception for loans that are used "to buy, build or substantially improve the taxpayer's home that secures the loan."
Can You Buy Land With a Conventional Mortgage?
No, you cannot buy raw (undeveloped) land with a conventional mortgage. Seller financing, a United States Department of Agriculture (USDA) loan, or a home equity loan on property you already own are among the ways to finance a land purchase. Paying cash, if you can come up with it, is another option.
Is Land a Good Investment?
Proponents of investing in land argue that it is a good investment because people will always need somewhere to live, grow food, and build things. As the saying goes, they aren't making any more of it. But land can be a risky proposition, especially for small investors. Property taxes, zoning changes, high development costs, and maintenance expenses can quickly eat into any potential profits and make the land a financial burden for the owner.
Can You Use a Home Equity Loan to Invest in a REIT?
If the risks of buying, managing, and developing actual land are too much for you, you might consider investing in a real estate investment trust (REIT). A REIT essentially pools money from many investors to buy and manage a diverse portfolio of properties. While you could use a home equity loan to buy into a REIT, borrowing against your home to invest in anything is rarely a good idea.
The Bottom Line
While you can use a home equity loan to buy land (or anything else), land is an inherently risky investment that may not be worth risking your home for. If you decide to proceed, make sure you've planned for the many costs that come with maintaining and developing land before you ever see a return on your investment. In some cases, using a home equity loan to expand your existing home's lot size could be a good financial decision, as it can increase your home's value when you eventually sell.