A Guide To FHA Construction Loans

Need to pay for a major kitchen remodel? Or maybe you need to fund the construction of an entirely new home, including the purchase of the land on which it sits? An FHA construction loan could help. You’ll just need to understand how these loans work and how they differ from a standard FHA loan.

What Is An FHA Construction Loan?

Federal Housing Administration (FHA) construction loans allow you to finance both major or minor renovations to an existing home or the construction of a new home from the ground up. Like standard FHA mortgages, these construction loans are backed by the government. Because of this, you can typically qualify for these loans with a lower credit score than you’d need when applying for standard, short-term construction loans.

You’ll need to meet certain requirements, though, to take out one of these loans. And depending on the work you’re doing, you might need to meet with a loan consultant to make sure your construction project meets FHA construction loan guidelines.

A construction loan differs from a traditional mortgage in that you use this type of loan to fund the construction or renovation of a home. A traditional mortgage is instead used solely to purchase an existing home.

Types of FHA Construction Loans

There are two main types of FHA construction loans. The one you’ll need depends on whether you are building a home or buying an existing home that needs renovations.

FHA Construction-To-Permanent Loan

An FHA construction-to-permanent loan covers the costs of buying land and building a home. Then, once the construction of your home has finished, your lender converts the construction loan to a permanent loan. You'll pay this permanent loan off like you'd pay off any mortgage loan: making monthly payments, with interest, until you pay off the loan's principal balance.

You'll only go through the closing process once on an FHA construction-to-permanent loan. That's a plus: Closing costs can be pricey, running from 2% – 6% of the total amount of money you’re borrowing. Going through more than one closing, then, could significantly increase your costs.

An FHA construction-to-permanent loan starts as a short-term construction loan. Under FHA rules, your lender must approve the contractor you have chosen to build your home. Once this happens, your lender will draft a draw schedule for the loan based on the estimated construction process. With each draw, your contractor will be paid so that construction on your home can continue.

Once your home's construction is done, your lender will convert the short-term construction loan to a permanent mortgage, usually with a term lasting 15 to 30 years. You'll then make regular monthly payments until you pay off this loan.

FHA 203(k) Rehabilitation Loan

But what if you’re not building a home from scratch? That’s when an FHA 203(k) rehabilitation loan can help. There are two main types of rehab loans offered by the FHA, but both allow you to roll the costs of rehabbing or renovating a home that you’re buying into your loan amount.

• Limited 203(k) mortgage: The FHA's Limited 203(k) loan allows you to add up to $35,000 to your loan amount to be used for renovating or rehabbing a home that you’re buying. Maybe the home you’re buying costs $250,000, but you determine that you’ll need $25,000 to renovate its aging kitchen. Instead of applying for a $250,000 purchase loan, you’d instead take out a loan for $275,000 to cover both the costs of buying the property and renovating it. Once you close on the loan, you pay it back in regular monthly payments, with interest.
• 203(k) mortgage: A standard 203(k) mortgage is designed for buyers taking on more expensive repairs after buying a home, ones that cost more than $35,000. Before earning approval for this loan, you’ll have to meet with an FHA-approved 203(k) consultant who will review your project and approve or reject it.

You'll have to apply for either of these loans with an FHA-approved lender that offers these loans. While most mortgage lenders are approved to originate FHA loans, not all lenders provide construction loans. For example, Rocket Mortgage^® does not offer FHA construction loans at this time.

How Does A One-Time Close FHA Construction Loan Work?

Ready to apply for an FHA construction loan, either a construction-to-permanent or 203(k) mortgage? Here’s what you can expect.

1. Get Preapproved For A Mortgage

During the preapproval process, a mortgage lender will review your credit and verify your income to determine how much of a loan it can give you. Getting preapproved is a key step in the FHA lending process: It lets you know how much you can afford to spend on either building a home or buying an existing one.

During this process, your lender will check your credit report and credit score. To qualify for an FHA loan, you need a FICO credit score of at least 500. Be aware, though, that many lenders won’t approve you for a mortgage unless your score is higher, often 580 or higher.

Lenders will also review your finances and require you to provide copies of such key documents as your two most recent paycheck stubs, 2 months of bank account statements and the last 2 years of your tax returns.

2. Select A Plot Of Land

If you’re building a new home, you’ll have to select a plot of land. Make sure this land meets the requirements of the FHA. For example, you can’t take out an FHA construction loan if your land sits near an oil or gas well, is too close to an airport or is near an area that is likely to suffer from floods.

3. Work With An FHA-Approved Consultant

If you’re taking out a 203(k) loan of $35,000 or more, you'll need to work with an FHA-approved 203(k) consultant. This professional will review your project plans and the contractors you have hired to make sure they meet FHA construction standards.

You won't need to meet with one of these consultants if you are taking out a 203(k) loan for $35,000 or less. You also won't need a consultant to apply for an FHA construction-to-permanent loan, though you will need to provide documentation to your lender showing that you are working with a licensed contractor.

4. Close On Your Construction Loan

In many ways, applying for an FHA construction-to-permanent or 203(k) loan is much like applying for any mortgage loan. Your lender will review your credit report and credit score.

The process does differ in some ways, though. For a construction-to-permanent loan, you'll first close on a short-term construction loan that will only last while construction is taking place. Once construction is over, your lender will convert the loan to a standard primary mortgage. You can choose the term of your new loan – two popular choices are 15 and 30 years – and begin making monthly payments, with interest, until you pay off the loan.

With an FHA 203(k) loan, you'll close for an amount higher than your home's purchase price, with this extra money being used to fund planned renovations. If your home costs $250,000 and you plan on $50,000 of renovations, you'd take out a standard 203(k) loan for $300,000, using the extra $50,000 to cover your home's repairs.

FHA Construction Loan Requirements

To qualify for any FHA construction loan, you’ll need to meet certain requirements.

Loan Eligibility Requirements

• Credit score: You’ll need a FICO^® credit score of at least 500 if you want to qualify for an FHA loan requiring a minimum down payment of 10% of your home’s purchase price. If your credit score is at least 580, you can qualify for an FHA loan with a minimum down payment of 3.5%. Just remember: Not all lenders will approve you for a loan, even an FHA loan, if your credit score is lower than 580.
• Debt-to-income ratio (DTI): Your debt-to-income ratio (DTI) measures the relationship between your gross monthly income – your income before taxes are taken out – and your monthly debts. Lenders vary, but most want your total monthly debts to be no more than 43% of your gross monthly income.
• Down payment requirements: A lower down payment is one of the main benefits of an FHA construction loan. Many construction loans require a down payment of at least 10%. Depending on your credit score, you may qualify for an FHA construction loan with a down payment of just 3.5%.

Additional FHA Construction Loan Requirements

All FHA borrowers must pay for FHA mortgage insurance, both an upfront fee and an annual fee. Borrowers pay 1.75% of their loan amount as an upfront payment when they first take out their loans. Borrowers also must pay an annual mortgage insurance premium (MIP), which varies according to the size of their down payment, the term of their loans and the size of their loans. This annual payment typically varies from 0.15% to 0.75% of borrowers' loan amount.

Who Offers FHA Construction Loans?

To apply for an FHA construction loan, you’ll need to find a mortgage lender approved by the U.S. Department of Housing and Urban Development (HUD) to originate FHA loans. You can find a list of these lenders here. The challenge? Not all lenders approved to originate FHA loans offer construction loans. You’ll have to search FHA-approved lenders in your area to find those willing to originate them.

Alternatives To FHA Construction Loans

FHA-insured loans aren’t your only choice to finance the construction or renovation of a home. You can turn to several alternatives, some of them also insured by a government agency.

VA Construction Loan

You can fund the construction of a new home with a VA construction loan, a mortgage product insured by the U.S. Department of Veterans Affairs (VA). The main benefit of a VA construction loan is that you don't have to come up with any down payment at all. The catch? Not everyone can qualify for a VA loan. You must be a veteran or active-duty member of the U.S. Military, or an eligible spouse, to qualify for a VA construction loan.

USDA Construction Loan

The U.S. Department of Agriculture (USDA) offers its own construction-to-permanent loan. And as with a VA loan, you won’t have to provide any down payment when taking out a USDA loan. The challenge here, though, is that not everyone can qualify for one of these loans, either. You must be buying or building a home in an area that the USDA considers rural. To find out whether the land on which you want to build is in an area designated as rural, check the USDA’s property eligibility site.

Local And State Construction Loan Programs

Your state or local government might offer their own loan programs designed to help buyers build a home or renovate an existing property. It’s best to check with local housing organizations or state departments to find out if your state or community offers such programs.

FHA Cash-Out Refinance

If you’re looking to renovate your current home and have already built substantial equity in it, consider a regular or FHA cash-out refinance, which allows you to borrow against your home’s equity. With this type of loan, you can refinance your current mortgage into a new one for more than you owe and use that extra money to make renovations and home improvements.

The Bottom Line

Whether you’re building a home from scratch or buying a fixer-upper, you can finance your purchase with an FHA construction loan. You can also seek alternatives if a construction loan isn’t the right choice. Ready to make the move to homeownership? Apply for a mortgage with Rocket Mortgage today.