If you’re familiar with FHA loans, you know that they can provide a path to homeownership for buyers who otherwise may not be able to qualify for a mortgage. What you might not know is that these loans can also help you build a new home or renovate one you plan to buy.
An FHA construction loan combines the advantages of a traditional FHA loan — namely, more relaxed lending requirements than a conventional mortgage — with the benefits of a short-term construction loan, which can be harder to qualify for and tends to require a higher credit score, a 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 roll the costs of building or renovating a home into an FHA mortgage loan. The construction loan, backed by the Federal Housing Administration, covers expenses including the purchase of land, building materials, construction work and permitting fees.
Just like a traditional FHA loan, these loans make it possible to build a home with a down payment as low as 3.5 percent or a credit score as low as 500.
FHA construction loan types
There are two types of FHA construction loans:
An FHA construction-to-permanent loan finances the ground-up 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 cash upfront to purchase land and build a home, then converting to a permanent mortgage once the construction is complete.
FHA 203(k) loan
An FHA 203(k) loan, also known as a mortgage rehabilitation loan, finances the renovation of a home, usually a fixer-upper. This loan allows you to purchase an existing home and remodel it, or renovate a home you already own, through a single mortgage.
There are two types of 203(k) loans:
- Standard 203(k): Generally for financing larger renovation projects costing $35,000 or more, this loan pays for a minimum of $5,000 in repairs, and requires the use of a 203(k) consultant — a home inspector or architect who will oversee each step of construction.
- Limited 203(k): This loan covers minor remodeling and non-structural repairs costing up to $35,000. You can work with a 203(k) consultant as you progress through the project, but it’s not required.
How FHA construction loans work
For either type of FHA construction loan, you’ll first need to apply through an FHA-approved lender. You can find a list of qualified lenders through the U.S. Department of Housing and Urban Development.
After the lender determines what you qualify for, you’ll choose a contractor for the project. With an FHA construction-to-permanent loan, your lender will need to approve the contractor before you can proceed. With either loan type, your lender will also need to approve all of your contractor’s plans before you can close on the loan. After closing takes place, construction or renovations can start.
Note that with any FHA loan, including a construction loan, you must pay mortgage insurance premiums. These include a one-time upfront premium, which is 1.75 percent of the amount of the loan, plus an annual premium that varies and can be paid in monthly installments.
Applying for an FHA construction loan
FHA construction loans call for the same qualifications as a traditional FHA mortgage loan, but with a few added requirements.
First, to qualify for any FHA loan, you must:
- Maintain a credit score of 580 or higher (or at least 500 if putting down 10 percent)
- Maintain a debt-to-income ratio of no more than 43 percent
- Make a down payment of at least 3.5 percent (10 percent if your credit score is 579 or lower)
- Make sure your loan amount does not exceed FHA loan limits
If you’re applying for an FHA construction-to-permanent loan, you must also provide documentation showing you’ll be working with a licensed general contractor. For a standard 203(k) loan, you’ll need to work with an approved 203(k) consultant. In addition, for any kind of loan and project, you’ll be required 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 lending requirements to specific groups that qualify. There are also private construction loans that may offer better terms if you meet the qualifications.
- Conventional construction loan – Conventional construction loans are available through banks and other lenders. They may be harder to obtain than an FHA construction loan, often requiring a down payment of 20 percent or more, but they can cost less if you have a higher credit score.
- State and local programs – New construction and home rehabilitation loans may be available for low- to moderate-income borrowers through the local government, nonprofit organizations or local housing authority.
- Fannie Mae and Freddie Mac construction loans – Fannie Mae offers a few different loan types to help finance new construction and home renovations. These include construction-to-permanent financing for new builds and the HomeStyle Renovation loan for improvements to a home you own or plan to purchase. Freddie Mac’s CHOICERenovation loan also provides financing for renovations.
- USDA construction loan – The U.S. Department of Agriculture administers construction-to-permanent loans to low- to moderate-income borrowers wanting to build a home in an eligible rural area.
- VA construction loans – Military members and veterans can obtain a VA construction loan backed by the U.S. Department of Veterans Affairs. No down payment or mortgage insurance is necessary, and these loans often offer lower interest rates, as well.