If you’ve always wanted to build your own home but your credit is too low for a conventional mortgage, an FHA Construction Loan is a great option.
With minimum credit scores as low as 500, FHA Construction Loans require only a 10% down payment, making it one of the best options for first-time buyers who don’t want to put down 20%.
In this article, we’ll explain where to get approved for an FHA construction loan and how to use it to build your new home.
Types of FHA Construction Loans
The cost of building a home can be rolled into the loan from the start with an FHA construction loan.
The FHA offers two types of construction loans: construction-to-permanent loans and 203(k) construction-to-permanent loans.
Construction-to-permanent loan. A construction-to-perm loan is an all-in-one FHA loan used to construct a home. It is possible to combine the costs of purchasing your own land, building, and lender fees into a single loan.
FHA 203(k) rehabilitation loan. If you want to buy a home that needs some serious TLC and upgrades, the FHA 203(k) program is for you. The FHA 203(k) loan program can be used to purchase or refinance a fixer-upper home.
FHA Construction Loan Requirements
FHA construction-to-permanent loans are subject to a number of rules, including requirements for the borrower, the property, and the contractor.
- Minimum of 3.5% down payment. That is the bare minimum for FHA loans.
- In theory, a FICO score of 580 is all that is required to qualify for FHA financing. However, for the FHA construction program, a credit score of at least 640 is usually required.
- You must not have declared bankruptcy within the last two years.
- Debt-to-income ratio (DTI) less than 43%. That is, your monthly debts, including future mortgage payments, should not exceed 43 percent of your monthly pre-tax income.
- 2 years of employment and income. For W-2 borrowers, this means the most recent 60 days of pay stubs, the most recent two years of W-2s, and your most recent two annual tax returns. Borrowers who are self-employed must provide the most recent two years of full personal and business tax returns, as well as all tax schedules involved.
Furthermore, all FHA borrowers must pay a mortgage insurance premium (MIP), which protects the lender in the event of a foreclosure.
FHA MIP has an upfront cost of 1.75 percent of the loan amount (which can be rolled into the mortgage) and an annual charge of 0.85 percent of the loan amount that is paid monthly.
MIP is typically required for the duration of the loan. Once a homeowner has 20% equity in their home, they can often refinance to cancel mortgage insurance and lower their monthly payments.
Pros and Cons of an FHA New Construction Loan
This loan is designed to compete with the more expensive and time-consuming traditional construction loan program; otherwise, you’d have to deal with multiple loans, multiple underwrites from different banks and underwriters, multiple appraisals, multiple fees, and multiple possible changes in economic conditions that could impact interest rates in desired outcomes.
The requirements are not as lenient as those for a traditional FHA loan. For example, you may require a higher credit score. Furthermore, because there is a lot more paperwork and red tape involved, the process will take much longer than a traditional mortgage.
You must determine whether this loan is appropriate for your needs based on your timeline, budget, credit score, and other factors.
How an FHA Onetime Close Construction Loan Works
The FHA construction–to–permanent loan process consists of four steps.
- First, you must be pre-qualified by a lender.
- The loan is then approved for your builder and general contractor.
- Following that, your home design plans are approved for the loan.
- Finally, you close on the loan and begin the construction of your dream home.
FHA 203(K) Rehabilitation Loan
If you’ve found a fixer-upper home to purchase or if your current home requires upgrades, an FHA 203(k) loan can help you remodel the home and roll the costs into your total loan amount.
In contrast to an FHA construction loan, the FHA 203(k) program allows you to make minor repairs or major renovations to an existing home.
There are two types of FHA 203(k) loans: limited and standard.
- Limited 203(k) loans. You can make improvements to a one to four-unit home for remodeling projects costing $35,000 or less. You can, for example, replace a leaking roof, install new carpet, or repaint the interior of your home.
- Standard 203(k) loans.The standard 203(k) program enables you to undertake larger renovations on a home you’re buying or refinancing. You can tackle a broader range of home improvement projects, including:
- Plumbing replacement in an older home
- Creating a wheelchair-accessible home
- Changing the structure or layout
- Landscaping additions or enhancements
FHA Construction Loan Interest Rates
Expect to pay a higher interest rate on an FHA construction–to–permanent loan than on other types of loans.
Borrowers are typically subjected to rates that are 2% to 4% higher.
In comparison, the interest rate on a conventional construction loan may be around 1% higher than market rates.
Because the home, which normally serves as collateral, does not yet exist, lenders generally view these loans as higher risk.
The interest rate on these FHA loans can also change depending on the borrower’s creditworthiness and other factors.
Locking in Your Interest Rate During Construction
Your interest rate may change while your house is being built. Ask your loan officer about rate lock options and the following questions:
- How much could rates fluctuate during construction?
- When can I lock in my interest rate during the FHA loan application process?
- What will the interest rate on the permanent mortgage be?
- Can I float a rate if it falls after my house is built?
- Complete the loan process and begin construction.
Your credit will be evaluated during this time, and your land and builder contracts will be underwritten and approved. Your lender will also confirm that you have homeowners insurance, set up your title, and calculate all final numbers for underwriting.
Once the underwriters have signed off, the construction team will sign off, the documents will be drawn, and you will proceed to closing.
Construction can begin once the loan is closed.
The loan funds will be held in an escrow account, and your contractor will be paid in installments as each phase of construction is completed.
Applying for an FHA Construction Loan
If you’re thinking about getting a 203(k) loan, you should consult with a 203(k) consultant to plan and price out the work you’ll need for your project.
You’ll also need to start looking for and vetting contractors for your projects.
To check eligibility and begin the process, give us a call. We’d be happy to help.