Taming Building Costs With an FHA Construction Loan

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Taming Building Costs With an FHA Construction Loan

Planning to build a new house or buy a fixer-upper? If so, you may already be considering a home construction loan to help juggle costs.

Loans are available from private lenders, but if you have a low credit score and limited resources for a downpayment, an FHA construction loan can help.

The Federal Housing Administration (FHA) offers building help through special, all-in-one construction loans that are often more affordable and approved more quickly. These loans are designed to allow prospective homeowners to either build a home from the ground up or buy a home that needs special attention and renovate it quickly.

FHA-backed mortgages have always been popular with consumers because they typically come with lower credit score and down payment requirements and fewer closing costs. FHA construction loans often come with the same benefits, since the FHA insures the loan, making it easier for your lender to offer you a good deal.

The biggest benefit to an FHA construction loan: It eliminates the hassle and costs of having to get two separate loans — one for buying a home and one for construction expenses. That means it eliminates the need for two loan approvals and two closings. Ultimately, consumers get a single loan that might be approved in two to 12 weeks.

For an FHA loan to work for you, you may need to follow certain building requirements (see more below). Still, compared to construction loans from private lenders, rates with FHA loans are often lower.

The loans can also help you get a good deal if your credit history isn’t ideal. For example, a credit score of less than 580 (but higher than 500) might still qualify you for financing with 10% down, but 580 is the minimum if you decide to go with a down payment of just 3.5%.

The FHA is part of the U.S. Department of Housing and Urban Development (HUD), and HUD guidelines can help you determine what kind of FHA loan you might be entitled to, based on both your credit score and your loan-to-value (LTV) ratio, a common way lenders assess the riskiness of a loan. The higher your credit, the more likely your lender will be comfortable with a riskier loan that carries a higher LTV. If your credit score is too low, you will not be eligible for a loan at all.

While these guidelines are official, HUD cautions some mortgage lenders impose loan requirements that go above the minimums it sets for FHA loans.

With an FHA construction loan, you typically close on the mortgage before starting construction, and funds are put into an escrow account and disbursed as your building project goes through inspections. You have the option of paying off the balance of the loan when construction is complete, or you can convert the loan into a conventional mortgage when you refinance and receive approval from the FHA.

Types of FHA construction loans

The FHA backs two types of construction loans: construction to permanent loans and 203(k) rehabilitation loans.

Construction to permanent

This loan might be best if you have a specific construction plan, complete with a timeline, as the lender pays the builder while the work is being done.

During construction, the lender disburses the money monthly to the builder as the work continues. The interest rates are variable during this period, and the buyer is expected to make interest-only payments. After your home is complete, the loan converts to a permanent mortgage, and the buyer is responsible for principal and interest payments.

203(k) rehabilitation loans

There are two types of 203(k) loans:

  • Limited — This type of loan lets homebuyers and existing homeowners borrow up to $35,000 to repair or improve a home. It’s usually used for smaller renovations, such as renovating a kitchen or bathroom, painting or putting in new flooring. The loans may be used to improve your own home or in preparation to sell it. If you’re sure the sale of your home will cover the loan amount — and the repair work is mostly cosmetic — then this might be a good choice.

    Standard — This type of loan is the main way the FHA helps homeowners rehabilitate single-family homes, and it’s a key player for revitalizing neighborhoods and communities. With a loan like this, a homeowner might be able to avoid the high interest rates, balloon payment plans and short repayment terms that often come with home improvement loans.

    Still, there are restrictions: your home needs to be at least one year old, the rehab must cost at least $5,000, and the value of the property must fall within the FHA mortgage limit for your area. Lenders may also charge additional fees, such as a supplemental origination fee, a higher appraisal fee or a fee to cover the cost of preparing architectural documents. The good news: Eligible homes can range from needing just $5,000 in repairs to those that are basically teardowns.

    To find a lender for this type of a loan, search here.

How to apply for an FHA construction loan

According to The Associated General Contractors of America, a leading trade group for the construction industry, lenders look at the following before making any construction loan:

  • Your credit score
  • The likelihood new construction will generate enough revenue for the loan to be repaid on time
  • The expertise and financial standing of the property owner, contractor and architect. For example, lenders may ask whether the contractor is bonded (or bondable). The contractor should also be able to provide key documents, such as a construction schedule and budget
  • The value of any collateral, such as mortgage collateral

Need to know

Don’t expect a construction loan to cover 100% of the cost of your project; lenders generally expect homeowners to contribute, too. Most lenders put a cap on loans using an LTV ratio that is typically 70% or less, depending on the lender, the project and other factors. A lender will probably also require a project budget that anticipates possible expenses and spells out funding sources and cash flow.

FHA construction loans often come with specific building demands, such as requiring construction to be completed within a year. Before going for any loan, check to see whether your lot or existing home has any building restrictions and look for a reputable builder with a proven track record of delivering high-quality construction on time and on budget.

Alternatives to FHA construction loans

Private lenders If you plan to quickly flip a home or make a renovation that will take less than a year — and don’t qualify for other loans or you need money fast — consider a private loan or an FHA Title I loan from a bank or qualified lender. FHA Title I loans can be used for any home improvement — even to replace a dishwasher. The maximum allowable amount for a single family property improvement loan is $25,000, and the amount rises for multi-unit homes. Rates, terms and qualifications for these loans vary.

An energy efficient mortgage (EEM) If you’re considering making energy improvements, this type of mortgage pulls together the energy-related aspects of your construction into a single, 15- to 30-year mortgage. The premise is that energy-efficient products will lower bills and in turn help cover the cost of the mortgage.

You can secure an EEM when either buying a home or refinancing. The loans come with interest costs that are often tax-deductible and can be combined with an existing home purchase of refinance. The downside: An EEM may require lots of paperwork, and not all lenders offer it.

Home equity line of credit (HELOC) A HELOC loan usually equals 85% of the value of your home less the amount you owe on your mortgage. You can decide how to use it, whether for a home renovation, a second home, a vacation or some other purpose.

HELOC users borrow money during a draw period and only pay interest on what they borrow. HELOC interest rates are typically variable. If fixed interest rates are available, they may be initially higher than the variable interest rates. To qualify for this type of loan, you’d need an LTV ratio of about 80% (find your ratio here) and a strong credit score (find yours here). You should also have a low debt-to-income ratio and enough income to cover mortgage payments.

The bottom line

An FHA construction loan can help with both the hassle and financial sting of building or renovating a home once you determine the loan that best fits the scope of your project, your building timetable and your budget. Still, this type of loan might not be the best option if you are a do-it-yourself renovator or own investment properties, so it’s important to balance the pros and cons before deciding which loan to pick.

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