What is an FHA construction loan?

What is an FHA construction loan?

An FHA construction loan is a type of FHA loan used to build a home. It works like a conventional construction loan by providing short-term financing to cover construction costs, including the land, building materials and labor. Often, borrowers convert these loans to long-term mortgages once the house is built.

Unlike conventional construction loans, however, FHA construction loans are insured by the Federal Housing Administration (FHA). That means if you have a credit score of at least 580, you could obtain a loan with a down payment of as little as 3.5%.

How does a construction loan work?

Construction loans aren’t the same as regular mortgages. They typically have a term of just one year, during which the lender has the property inspected on a regular basis and releases payments — usually directly to your contractor — as milestones are met. Once construction is finished, the loan either converts to a traditional mortgage or the borrower obtains a mortgage to pay it off.

Types of FHA construction loans

There are two types of FHA loans meant to cover construction: One for new-build homes, and another for existing homes that need work.

1. FHA one-time-close construction-to-permanent loan: A construction-to-permanent loan finances the ground-up construction of a home — including the purchase of the land or lot — then converts to a regular FHA mortgage when the build is complete. It’s also known as a one-time or single-close loan, meaning you won’t have to pay closing costs for two separate loans.
2. FHA 203(k) rehab loan: An FHA 203(k) loan finances the cost of buying an existing home and completing renovations and repairs. The standard type is for major renovations, and there’s also a limited 203(k) for smaller-scale, less-expensive projects. Either option allows you to obtain one loan, instead of two, to buy and rehab a home.

FHA construction loan requirements

The qualifying requirements for an FHA construction loan are similar to those for standard FHA loans — but with a few additions.

To qualify for any FHA loan, you must meet the following criteria:

• Credit score: At least 580, or as low as 500 if putting down at least 10%.
• Debt-to-income ratio: Your DTI ratio must be no more than 43% (with some exceptions).
• Down payment: A minimum of 3.5% with a credit score of at least 580, or at least 10% with a credit score between 500 and 579.
• Loan limits: No more than the FHA loan limits for that year. For 203(k) loans, it’s no more than the FHA loan limits; or the home’s after-renovation value plus improvement costs; or the home’s after-renovation value — whichever is less. You can search for the limit in your area using the FHA’s lookup tool.
• Mortgage insurance: You’ll pay an upfront FHA mortgage insurance premium, typically 1.75% of the loan amount, as well as a monthly premium for the life of the loan (in most cases).
• Occupancy: Available for primary residences only — you can’t use an FHA construction loan for a second home or investment property.

On top of these requirements, FHA construction loans require documentation about the construction project and the contractor you plan to use. For a standard 203(k) loan, you’ll be assigned a 203(k) consultant to estimate the remodeling or repair costs. For either type of loan, the work will be subject to inspections as the project progresses.

How to get an FHA construction loan

FHA construction loans are offered by many FHA-approved lenders, though not all of them. If you’re not sure where to start, search the list of lenders on the U.S. Department of Housing and Urban Development (HUD) website by state or county.

From there, the process involves connecting with a contractor and getting preapproved for financing. Here’s an overview:

1. Prepare your credit and finances: Construction loan interest rates are often higher than the rates for a typical mortgage. While you can get an FHA loan with a relatively low credit score and down payment, a better score and a higher down payment could help you get a lower rate and pay less in mortgage insurance. If you plan to build a brand-new home, you’ll also want extra cash saved for the inevitable budget overruns that arise during construction.
2. Partner with a real estate agent: A knowledgeable local real estate agent can help you find the right parcel of land, lot or fixer-upper for your needs. Your agent may also be able to help connect you with reputable contractors in your area.
3. Find a contractor: Whether you plan to build a new home or renovate an existing one, you’ll need to work with a contractor to estimate your costs and draw up plans. Your lender will want these in order to approve your loan. If you’re getting a 203(k) loan, you’ll also work with a 203(k) consultant.
4. Get preapproved: You’ll need to meet FHA loan requirements and any other criteria your lender stipulates. If you qualify, your lender will base the loan amount on the appraised after-construction or after-renovation value of the home.

How to choose an FHA construction loan lender

Many types of mortgage lenders offer FHA loans, but not all offer new-construction FHA loans. You can search FHA-approved lenders in your area on the HUD website, or start with our guide to the best FHA mortgage lenders.

Once you’ve found a few lenders you like, research them the way you would any other lender, including reading reviews and scheduling a chat with a loan officer. Make sure your lender offers competitive rates and low fees, and that the rep you’re assigned is responsive and helpful. If possible, try to get preapproved with three lenders so that you can choose the best deal.

Alternatives to an FHA construction loan

An FHA construction loan is just one type of construction financing. Here are alternatives to consider:

• Conventional construction loans: More widely available than FHA construction loans, conventional construction loans include construction-to-permanent and construction-only options. On the plus side, you won’t have to pay mortgage insurance for the entire loan term, unlike most borrowers with an FHA loan. But there are downsides: You’ll need to come up with a higher down payment than with an FHA-backed loan, and the minimum credit score required is usually higher.
• Renovation loans: Instead of a 203(k) loan, you might look into Fannie Mae’s HomeStyle renovation loan, which can provide financing for up to 75% of the purchase price plus reno costs or the final appraised value (whichever is lower).
• VA or USDA construction loans: If you’re a service member or veteran, or you have a lower income and want to build a home in a qualifying rural area, consider a VA or USDA loan, respectively. These don’t require a down payment or mortgage insurance and can have flexible credit standards, but you’ll need to pay a one-time funding fee for the VA loan and guarantee fees for a USDA loan.
• Home equity options: If you want to make improvements to your home or another property you own, and you’ve built up some equity, consider a home equity loan or home equity line of credit, known as a HELOC.
• Cash-out refinance: If interest rates have declined since you got your mortgage, you might be able to refinance to a new, bigger loan with a lower rate and cash out some of your equity to pay for renovations.

FAQs

• What are FHA construction loan interest rates?

  The national average rate for FHA loans in general has hovered around 6% recently, alternating between a bit higher or a bit lower than that mark. An FHA construction loan will often run slightly higher, although exact rates vary depending on your lender and your risk level as a borrower.

• What are the pros and cons of FHA construction loans?

  One of the main pros of an FHA construction loan is that the qualification requirements are usually less strict compared to conventional construction loans — it requires a lower minimum credit score, for example. However, there are negatives as well, including being subject to the FHA’s mortgage insurance premiums, loan limits and consultant requirements.