How FHA Construction Loans Work

If you know FHA loans, you know they can pave the way for homeownership for buyers who might not otherwise qualify for a mortgage. What you may not know is that these loans can also help you build a new home or renovate the one you are considering buying.

An FHA construction loan combines the advantages of a traditional loan FHA loan – that is, more flexible loan requirements than a conventional mortgage – with the advantages of a short-term mortgage ready to build, which can be more difficult to obtain and typically requires a higher credit score, lower debt-to-income ratio, and a larger down payment than even a conventional loan.

What is an FHA construction loan?

FHA construction loans allow you to convert the costs of building or renovating a home into an FHA mortgage. The construction loan, supported by the Federal Housing Administration, covers expenses, including the land purchase, building materials, construction work and permit fees.

Much like a traditional FHA loan, these loans allow you to build a house with a down payment as low as 3.5% or a credit score as low as 500.

Types of FHA construction loans

There are two types of FHA construction loans:

Construction loan to permanent

An open-ended construction loan from the FHA finances the top-to-bottom construction of a new home. It combines the features of a short-term construction loan with those of a regular FHA loan, providing access to upfront cash to buy land and build a house, then converting into a permanent mortgage once construction is complete.

FHA 203 (k) loan

A FHA 203 (k) loan, also known as a mortgage rehabilitation loan, finances the renovation of a home, usually a renovation. This loan allows you to buy an existing home and renovate it, or renovate a home you already own, with just one mortgage.

There are two types of 203 (k) loans:

  • Standard 203 (k): Typically for financing large home improvement projects of $ 35,000 or more, this loan pays a minimum of $ 5,000 in repairs and requires the use of a 203 (k) consultant – a building inspector or architect who will supervise each stage of construction.
  • Limited 203 (k): This loan covers minor renovations and non-structural repairs of up to $ 35,000. You can work with a 203 (k) consultant as you progress through the project, but it is not required.

How FHA Construction Loans Work

For either type of FHA construction loan, you will first need to apply with an FHA approved lender. You can find a list of qualified lenders through the US Department of Housing and Urban Development.

Once the lender has determined what you are eligible for, you will choose a contractor for the project. With an FHA permanent construction loan, your lender will need to approve the contractor before they can proceed. Regardless of the type of loan, your lender will also need to approve all of your contractor’s plans before you can complete the loan. After closure, construction or renovations can begin.

Note that with any FHA loan, including a construction loan, you have to pay mortgage insurance bonuses. These include a one-time initial premium, which is 1.75% of the loan amount, plus an annual premium which varies and can be paid in monthly installments.

Apply for an FHA construction loan

FHA construction loans require the same qualifications as a traditional FHA mortgage loan, but with a few additional requirements.

First of all, to be eligible for an FHA loan, you must:

  • Maintain a credit score of 580 or higher (or at least 500 if 10%)
  • Maintain a debt-to-income ratio not exceeding 43%
  • Make a down payment of at least 3.5% (10% if your credit score is 579 or less)
  • Make sure your loan amount does not exceed FHA loan limits

If you are applying for an FHA indefinite construction loan, you must also provide documentation indicating that you will be working with a licensed general contractor. For a standard 203 (k) loan, you will need to work with a 203 (k) licensed consultant. In addition, for any type of loan and project, you will need to submit the plans to your lender.

Alternatives to an FHA construction loan

There are other types of construction loans, either federally backed or sponsored by a state or local government, that offer relaxed loan requirements to specific qualifying groups. There are also private construction loans that may offer better terms if you qualify.

  • Classic construction loan – Conventional construction loans are available from banks and other lenders. They can be more difficult to obtain than an FHA construction loan, often requiring a down payment of 20% or more, but they can cost less if you have a higher credit score.
  • State and local programs – New housing construction and rehabilitation loans may be available to low and moderate income borrowers through local government, non-profit organizations or the local housing authority.
  • Construction Loans from Fannie Mae and Freddie Mac – Fannie Mae offers different types of loans to help finance new construction and home renovations. This concerns in particular the financing of sustainable construction for new constructions and HomeStyle renovation loan for improvements to a home you own or are considering purchasing. Freddie mac’s CHOICE Renovation loan also provides funding for renovations.
  • USDA construction loan – The United States Department of Agriculture administers open-ended construction loans to low- and moderate-income borrowers who wish to build a home in a eligible rural area.
  • VA construction loans – Military and veterans can get a VA construction loan supported by the US Department of Veterans Affairs. No down payment or mortgage insurance is required, and these loans often offer lower interest rates.

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