What Is an FHA Construction Loan, and Who Can Qualify?

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If you’re looking to give your house some TLC or build your dream home from the ground up, an FHA construction loan might get you there. 

FHA construction loans provide an option for someone looking to build or update a home—but who doesn’t necessarily meet the requirements of a conventional mortgage. Thanks to the more flexible lending requirements, borrowers with low to moderate incomes or below-average credit still have a chance at homeownership.

Pro Tip

Before taking on any type of new debt, it’s helpful to talk to a credit counselor who can help you fit your goals into your overall financial plan. See our guide to 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 homebuyers and homeowners to either build a new home or make improvements to an existing home. It’s an all-in-one product; the loan covers all expenses associated with your build or renovation. The process begins with you finding a licensed contractor to do the work, then you can shop around for your FHA loan.

FHA-approved lenders underwrite the loans, which are insured by the Federal Housing Administration. Because these loans are designed for individuals with lower credit scores, the FHA guarantee helps to mitigate some of the risks for the lender.

Types of FHA Construction Loans

There are two primary types of FHA construction loans. One is intended for new builds, while the other is for homebuyers or homeowners looking to make significant improvements on their homes.

Construction-to-Permanent Loan

A construction-to-permanent loan combines a short-term construction loan with a typical FHA loan into a single product. You close on your loan once at the beginning of the process, then once the home 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 close on your construction loan, and then once the home was built, you would have a second closing on your mortgage.

“The FHA one-time close is a better product because it all closes at the same time,” Christopherson says. “There’s no room for error after the first half of the transaction has completed. It allows the borrower to reserve funds and minimize their down payment.”

One of the benefits of a one-time close is that borrowers don’t have to worry about changes in their financial situation impacting their second closing.

“If anything changed with their employment or financials before that second portion, it could impact them for closing on their construction loan,” Christopherson said. “This product couples it all together.”

FHA 203(k) Rehabilitation Loan

The FHA’s 203(k) program allows homeowners to purchase and/or renovate an existing home. 

There are two types. 

Limited 203(k) mortgage: This is where homebuyers and current homeowners can finance anywhere from $5,000 to $35,000 to improve or repair their homes. New homeowners can use this type of loan to improve their homes after moving in. Homeowners can also use a 203(k) loan to prepare their home for sale by making improvements to increase the property value.

Standard 203(k) mortgage: This is where homebuyers can finance both the purchase and the rehabilitation through a single loan. Buyers can use this type of loan to purchase a fixer-upper that’s at least a year old. The loan can be used for improvements such as structural alterations, modernizations, additionals, major landscaping, energy conservation improvements, and upgrades to eliminate health and safety hazards.

Can You Use a Construction Loan to Buy Land?

An FHA construction loan covers all of the costs associated with the build, including the 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 on an additional loan.

“An FHA construction loan may be used to purchase the land so long as the property is going to have a home built on it,” said Eric Nerhood, owner of Premier Property Buyers, a company that repairs and sells homes. “Once the home is built, the construction loan will roll into a traditional mortgage.”

Who Can Qualify for an FHA Construction Loan?

The requirements for an FHA construction loan are nearly identical to the requirements on any other FHA mortgage. To qualify for your loan, you’ll need:

  • A minimum credit score of at least 500 (or 580 for the lower down payment)
  • A down payment of at least 10% for credit scores 500 and above and at least 3.5% for credit scores 580 and above
  • A debt-to-income ratio of no more than 43%
  • Upfront and annual private mortgage insurance
  • No delinquencies 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 some unique stipulations of their own, such as a contract with a licensed builder.

“It’s common for the bank to ask for a permit from the builder,” says Thomas  Jepsen, founder of Passion Plans, a company that helps connect home buyers with architects and designers. “They ensure the builders have the necessary insurances.”

It’s also important to keep in mind that the FHA’s requirements aren’t the only ones you’ll have to contend with. Individual lenders can also set their own requirements.

“Even though the FHA has requirements in terms of what you need to be able to present, the banks are still allowed to stack things on top,” Jepsen says. “There are going to be lenders that won’t look at you until you have a 600 credit score, even though the actual FHA doesn’t require that.”

Conclusion

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 upgrade an existing home without letting below-average credit stand in the way.

Unlike typical home loans, the first step to qualifying for an FHA construction loan is finding a licensed builder. Shop around in your area to find reputable and trustworthy contractors. From there, you can visit the list of approved FHA lenders to find one near you.