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If you’re looking to give your home a little bit of attention or build your dream home from scratch, an FHA construction loan could get you there.
FHA construction loans provide an option for someone looking to build or renovate a home, but may not necessarily meet the requirements for a conventional mortgage. With more flexible loan terms, borrowers with low to moderate incomes or below average credit still have a chance to own a home.
Before accepting any type of new debt, it is helpful to speak with a credit counselor who can help you incorporate your goals into your overall financial plan. Check out our guide on free credit counseling.
Here’s what to know about an FHA construction loan and how they work.
What is an FHA construction loan?
An FHA construction loan is a type of mortgage that allows buyers and homeowners to build a new home or make improvements to an existing home. It is an all-in-one product; the loan covers all expenses related to your construction or renovation. The process begins with you finding a licensed contractor to do the job and then you can shop around for your FHA loan.
Lenders approved by the FHA guarantee the loans, which are insured by the Federal Housing Administration. Because these loans are designed for people with lower credit scores, the FHA guarantee helps mitigate some of the risk for the lender.
Types of FHA construction loans
There are two main types of FHA construction loans. One is for new construction, while the other is for buyers or homeowners who want to make significant improvements to their home.
Construction loan to a permanent loan
A permanent construction loan combines a short term construction loan with a typical FHA loan into one product. You close your loan once at the start of the process, then after the house is built, your loan is converted into a long-term FHA loan.
These loans have historically required two closings, according to Nicole Christopherson, real estate broker at NMC Realty. You would initially conclude on your construction loan, then after the house is built, you would have a second closing on your mortgage.
âThe single FHA closure is a better product because everything closes at the same time,â says Christopherson. âThere is no room for error after the end of the first half of the transaction. This allows the borrower to reserve funds and minimize their down payment. “
One of the benefits of a one-time closing is that borrowers don’t have to worry about changes in their financial situation affecting their second closing.
“If anything changes with their jobs or their finances before this second part, it could impact them for the closing of their construction loan,” said Christopherson. “This product combines all of that together.”
Rehabilitation loan FHA 203 (k)
The FHA 203 (k) program allows homeowners to purchase and / or renovate an existing home.
There are two types.
203 (k) Limited Mortgage: This is where current buyers and homeowners can finance between $ 5,000 and $ 35,000 to improve or repair their home. New homeowners can use this type of loan to improve their homes after they move in. Homeowners can also use a 203 (k) loan to prepare their home for sale by making improvements to increase the value of the property.
Standard 203 (k) mortgage: This is where buyers can finance both the purchase and the rehabilitation through a single loan. Buyers can use this type of loan to purchase a repairer who is at least one year old. The loan can be used for improvements such as structural alterations, upgrades, additions, major landscaping, energy conservation improvements and upgrades to eliminate health and safety risks.
Can you use a construction loan to buy land?
An FHA construction loan covers all costs associated with construction, including land, plans, permits, fees, labor, and materials. This is good news for FHA borrowers who may not have the financial means to purchase the land or take out an additional loan.
âAn FHA construction loan can be used to buy the land as long as the property is going to have a house built on it,â said Eric Nerhood, owner of Premier Property Buyers, a company that repairs and sells homes. “Once the house is built, the construction loan will turn into a traditional mortgage.”
Who Can Qualify For An FHA Construction Loan?
The requirements for an FHA construction loan are almost identical to those for any other FHA mortgage loan. To benefit from your loan, you will need:
- A minimum credit score of at least 500 (or 580 for the lowest down payment)
- A deposit of at least 10% for credit scores of 500 and above and of at least 3.5% for credit scores of 580 and above
- A debt-to-income ratio not exceeding 43%
- Initial and annual private mortgage insurance
- No arrears on FHA loans in the past three years
- A loan amount within the FHA loan limits
In addition to the standard FHA loan requirements, construction loans also have unique stipulations, such as a contract with a licensed builder.
âIt’s common for the bank to ask the builder for a permit,â says Thomas Jepsen, founder of Passion Plans, a company that connects homebuyers with architects and designers. “They make sure the builders have the necessary insurance.”
It’s also important to keep in mind that the FHA requirements aren’t the only ones you’ll face. Individual lenders can also set their own requirements.
âEven though the FHA has requirements in terms of what you need to be able to present, banks are still allowed to stack things on top,â Jepsen says. “There will be lenders who won’t look at you until you get a 600 credit score, even though the FHA doesn’t require it.”
Unfortunately, a low credit score can be a barrier for many to buying or building a home, but FHA construction loans can help individuals build a new home or improve an existing home. without leaving less than average credit.
Unlike typical home loans, the first step in qualifying for an FHA construction loan is to find a licensed builder. Shop in your area to find reputable and trustworthy contractors. From there, you can consult the list of FHA approved lenders to find one near you.