What is an FHA construction loan?

Many of us grow up imagining our dream homes. Maybe something close to it exists out in the world but, for many homebuyers, the only way you’re going to make that dream home a reality is by building it yourself.

Of course, that’s easier said than done. Buying a resale home is complicated and expensive enough, but finding the financing to purchase land and build a new home from the ground up is an even more significant endeavor. Fortunately, you may not have to take out separate home loans to buy land, build a home, and finance the finished home thanks to a program backed by the Federal Housing Administration (FHA).

FHA construction loans are three-in-one mortgages that cover land purchase, construction costs, and permanent mortgage financing in one. This type of loan saves you time, hassle, and likely money by financing your entire dream project with a single loan.

These construction loans can be difficult to find and have stricter requirements than normal FHA loans. Nonetheless, they may be a good option if you want to build a home.

What is an FHA construction loan?

An FHA construction loan is just like a regular FHA mortgage loan, except that it covers new construction homes rather than existing homes. Considering it might be cheaper to build a house than buy one in some cases, these loans aren’t necessarily more expensive than a typical FHA loan.

FHA construction loans let you roll the costs of building (or renovating) a home into a normal FHA mortgage loan, basically combining two products into one. The loan covers expenses for purchasing land, building materials, construction work, and permitting fees.

Like other FHA loans, FHA construction loans are designed to be more accessible than traditional new construction loans. You can build a home with a down payment as low as 3.5% or a credit score as low as 500.

Types of FHA construction loans

• FHA construction-to-permanent loans combine features of a short-term construction loan with those of a regular FHA loan. You get access to cash upfront to purchase land and build a home before converting the loan into a permanent mortgage after completing construction.

• FHA 203(k) loans, also known as mortgage rehabilitation loans, finance major home renovations. Typically used for fixing up a house in disrepair, this loan helps you purchase an existing home and remodel it, or renovate a home you already own through a single mortgage. Standard 203(k) loans are used for financing large renovation projects that cost more than $35,000 and require you to hire a 203(k) consultant. Limited 203(k) loans cover minor remodeling and non-structural repairs costing up to $35,000. With limited 203(k) projects, you’re not required to work with a 203(k) consultant.

What are FHA construction loan requirements?

FHA construction loans have the same basic requirements as traditional FHA loans, as well as a few additional requirements. Those standard buyer requirements are:

• Minimum credit score of 580 (or 500 with a 10% down payment).
• Maximum debt-to-income (DTI) ratio of 43%.
• Minimum down payment of 3.5% (or 10% with a credit score under 580).
• Must not have experienced bankruptcy in the past two years.
• Be able to verify at least two years of employment and income.

To qualify for an FHA construction loan, you must also:

• Ensure your desired loan amount does not exceed FHA loan limits.
• Provide documentation proving that you are working with a licensed contractor. For a standard 203(k) loan, you must also show that you’ve hired an approved 203(k) consultant.
• Some lenders may also require you to submit building plans for review.

Buyers should also remember that they must pay a mortgage insurance premium (MIP). FHA MIP has an upfront cost of 1.75% of the loan amount (rolled into the mortgage) and an annual charge of usually 0.85% of the loan amount paid monthly.

Once you have reached 20% home equity, you can refinance to get rid of mortgage insurance and lower your monthly payments.

FHA construction loan property requirements

In addition to buyer requirements, FHA construction loans are also subject to property requirements. These requirements include:

• Your total loan amount cannot exceed your county’s maximum loan limit. For 2022, most counties had a max FHA borrowing limit of $420,680 but the number may range up to $970,800.
• Eligible property types include single-family homes, condo units in approved projects or legal phases, and manufactured homes.
• The home must be the borrower’s primary residence and located in an FHA-approved area.
• The property is subject to FHA inspection.

How do FHA construction loans work?

Regardless of the type of FHA construction loan you pursue, you must apply through an FHA-approved lender. You can find a list of qualified lenders through the U.S. Department of Housing and Urban Development’s (HUD) website. However, while it is the most important step of the process, that isn’t the first step.

1. Find the land you want to build on

Before you move forward with anything, you should find the land you want to build on. You could use vacant land that you already own outright, land that you’re currently paying off with an existing loan, or land you want to acquire as part of the building process.

The most important consideration is that the land doesn’t already have property on it that will require teardown. You want vacant space.

2. Get pre-qualified for financing

Like a traditional mortgage loan, you must get prequalified with a lender before you can finalize your budget and building plans. The pre-qualification process is crucial for determining how much you can actually borrow. This is when you’ll find an FHA construction loan-approved lender and start to figure out how much you can afford.

3. Hire a builder and start designing

You don’t have to hire a builder before getting loan approval but it’s good to get a jump on it. That’s because not all builders will agree to work with the FHA construction loan program. That will narrow your options down but it’s smarter to find a builder who has worked with this loan program before since they’ll understand how to work on a project backed by the federal government.

It’s also wise to find a builder before pursuing loan approval because the lender will have to approve of all your contractor’s plans before officially closing on the loan.

Here's what to ask a home builder.

4. Get the loan and start building

Once the lender and your builder are in agreement on plans, the lender will order an appraisal to determine the complete property’s forecasted value. During this process, your loan application will receive final evaluation and the lender will confirm that homeowners insurance is in place, set up your title, and calculate the final numbers for underwriting.

After the loan closes, you can start building. All loan funds will stay in an escrow account and your builder will be paid in installments as they complete construction phases.

Pros and cons of FHA construction loans

Pros

• FHA construction loans are accessible to lower-credit borrowers, making dream homes possible for more potential buyers.
• Low down payments also give buyers additional liquidity during the construction process, which is a valuable asset when you’re renting while still paying off your FHA construction loan.
• A single loan covers land, home construction, and financing. That means you can use the money to make renovations as soon as you purchase a fixer-upper or design your home exactly how you like. It’s easier to make your vision a reality.

Cons

• Borrowing limits are in place to protect you but they can also be an inconvenience if you want a few little luxuries in your new home that your lender won’t allow. It may mean more borrowing for renovations in the future.
• All FHA loans require paying for mortgage insurance, something you might not have to do with a traditional loan.

There are other types of construction loans that may have less stringent buyer requirements, but if you have low credit or not a lot of liquidity, FHA construction loans offer an accessible way to build your dream home.