When starting the loan application process, one thing you should definitely check on if you have not already done so: do they loan on land? Here’s why this is important. I will take the example of one customer I am working with and use his situation to illustrate. He wants to buy a large property with a stunning new and large home, and a few old outbuildings. He would have nearly 300 acres and that comprises a large portion of the value of the property. If it were 5 acres, he would not be buying it for the same amount. Most of what I call the “Sunday paper banks” will loan on the home and the prime site, the lot on which it stands. For some that is an acre or two; others may go up to five or even ten. But not 300. And everything else, for the purpose of their appraisal, is worth $0. Their appraisers are instructed to ignore the rest of the land beyond the prime site. Sometimes they are told to ignore barns as well. Sometimes these banks are more liberal on their appraisal of the home than the more conservative banks I normally deal with, the ones that do allow the value of land to influence what they are willing to lend.
With this in mind, let's go through some figures to illustrate. Picking some numbers out of the air, let's say the home is worth $300000. His bank needs him to have 7% equity in order to protect their investment in him. If he is buying the entire property for $530000, they can then loan $493000. Maybe they are generous on the home appraisal and give it $350000. That still represents a shortfall of $143000. The land is easily worth that, and far more, so there is no problem IF they loaned on the land as well. But if they don’t; guess who makes up that shortfall? He does. So, now instead of needing only 7% down ($37000), he suddenly needs $180000 down. If they will loan on a few extra acres or the outbuildings (this varies), that number can come down a little bit. On the other hand, if they are less generous on the home appraisal, his down payment goes up correspondingly.
Now, compare a bank that will lend on land. They may require 20 or 25% down. Let's use 25%. In our example; that’s $132500 down. Suddenly the bank everyone rejects looks a lot better. In actuality it is more complicated than this. I have not discussed interest rates and length of amortization. Incidentally, length of amortization usually has a greater influence upon lowering your monthly payments than the interest rates do. It also has the greater influence upon how much you ultimately pay.
The failure of most banks to loan on land initially puzzled me as you’d think it would be the safest. Land does not burn, blow down or collapse under snow; buildings can and do. Yes, land can be clearcut or allowed to grow fallow but that kind of depreciation pales when compared to what can happen to buildings. That’s why no one gets insurance for the destruction of land. But there are other things going on. Big banks are great bean counters, the more so the bigger these banks get. When you get big, you start making regulations and you try to make the art of lending into a science. That leads to fitting square pegs into round holes. Farms are square pegs. The vast majority of real estate transactions are for homes, with businesses a poor second, so you plan for round pegs. Added to this is the fact that their loan officers don’t know or understand farms, nor are they equipped to determine how farming will affect an applicant's ability to service the loan. It’s bad business to loan on something you do not understand, so they don't.
Complicating things and adding to this square peg/round hole phenomenon are Federal regulations, the HUD thing. If a bank is going to sell its loans to another institution, they have to comply with HUD regulations. Farms don’t fit. HUD deals with homes, not farms, so that means a bank has to be prepared to keep any land or farm loans in house. That happens less and less anymore. Many banks sell ALL their loans. They have become mortgage originators not servicers. I think that trend is ultimately detrimental to our banking system, but we won’t go there now; others disagree and they are in positions of power that I sure don’t occupy. I have seen so many absolutely stupid mistakes big banks make, so many great opportunities missed due to the way their regulations tie the hands of their personnel. They are apparently willing to lose out 5% (or whatever) of the time to be right on the other 95%. They don’t worry about being right 100%.
With this in mind, let's go through some figures to illustrate. Picking some numbers out of the air, let's say the home is worth $300000. His bank needs him to have 7% equity in order to protect their investment in him. If he is buying the entire property for $530000, they can then loan $493000. Maybe they are generous on the home appraisal and give it $350000. That still represents a shortfall of $143000. The land is easily worth that, and far more, so there is no problem IF they loaned on the land as well. But if they don’t; guess who makes up that shortfall? He does. So, now instead of needing only 7% down ($37000), he suddenly needs $180000 down. If they will loan on a few extra acres or the outbuildings (this varies), that number can come down a little bit. On the other hand, if they are less generous on the home appraisal, his down payment goes up correspondingly.
Now, compare a bank that will lend on land. They may require 20 or 25% down. Let's use 25%. In our example; that’s $132500 down. Suddenly the bank everyone rejects looks a lot better. In actuality it is more complicated than this. I have not discussed interest rates and length of amortization. Incidentally, length of amortization usually has a greater influence upon lowering your monthly payments than the interest rates do. It also has the greater influence upon how much you ultimately pay.
The failure of most banks to loan on land initially puzzled me as you’d think it would be the safest. Land does not burn, blow down or collapse under snow; buildings can and do. Yes, land can be clearcut or allowed to grow fallow but that kind of depreciation pales when compared to what can happen to buildings. That’s why no one gets insurance for the destruction of land. But there are other things going on. Big banks are great bean counters, the more so the bigger these banks get. When you get big, you start making regulations and you try to make the art of lending into a science. That leads to fitting square pegs into round holes. Farms are square pegs. The vast majority of real estate transactions are for homes, with businesses a poor second, so you plan for round pegs. Added to this is the fact that their loan officers don’t know or understand farms, nor are they equipped to determine how farming will affect an applicant's ability to service the loan. It’s bad business to loan on something you do not understand, so they don't.
Complicating things and adding to this square peg/round hole phenomenon are Federal regulations, the HUD thing. If a bank is going to sell its loans to another institution, they have to comply with HUD regulations. Farms don’t fit. HUD deals with homes, not farms, so that means a bank has to be prepared to keep any land or farm loans in house. That happens less and less anymore. Many banks sell ALL their loans. They have become mortgage originators not servicers. I think that trend is ultimately detrimental to our banking system, but we won’t go there now; others disagree and they are in positions of power that I sure don’t occupy. I have seen so many absolutely stupid mistakes big banks make, so many great opportunities missed due to the way their regulations tie the hands of their personnel. They are apparently willing to lose out 5% (or whatever) of the time to be right on the other 95%. They don’t worry about being right 100%.
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