FHA Construction Loans | Requirements and Process 2024 (2024)

Can you build a house with an FHA loan?

With an FHA construction loan, you have the flexibility to buy a parcel of land, build a home from scratch, finance a permanent mortgage on the completed home, or even purchase and renovate a fixer-upper, all with a single loan.

While there are two types of FHA construction loans, both are three-in-one mortgage products that streamline the home building process by consolidating it into one loan, saving time, hassle, and expenses.

However, these loans might be challenging to find, and they often have stricter requirements compared to traditional FHA loans, making it important to understand what to expect before applying.

In this article (Skip to...)

• FHA construction-to-permanent loan
• FHA 203(k) loan
• How to get an FHA construction loan
• Loan requirements
• Lenders
• Interest rates
• Alternatives
• FAQ

What is an FHA construction loan?

Want to build a new home from the ground up and simplify the financing process? Look into an FHA construction loan, also called an FHA construction-to-permanent loan.

This loan option includes financing for a land purchase, home construction, and a permanent mortgage for the completed home — all in a one-time-close loan.

Instead of pursuing three separate loans for the land buy, home building, and mortgage — which would involve separate paperwork and closing costs — an FHA construction loan simplifies matters by combining it all in one underwriting process.

These loans are also government-backed by the Federal Housing Administration.

How does an FHA construction loan work?

An FHA construction loan is a specialized mortgage option that allows you to build a new home or renovate an existing one.

Because this loan allows construction costs to be added to the overall loan amount, it is a desirable option for borrowers with less-than-perfect credit. Notably, qualifying for an FHA construction loan might be possible with a credit score as low as 500, provided a 10% minimum down payment is made.

There are two types of FHA construction loans and each is designed to make homeownership more accessible, especially for first-time home buyers.

FHA construction-to-permanent loan

The FHA construction-to-permanent loan is a hybrid that combines the elements of a short-term construction loan with a traditional FHA mortgage. This versatile loan can be used to acquire land, finance construction costs, and cover lender fees.

It works as a construction loan at first, but when the building is finished, it converts smoothly into a permanent mortgage. This transformation eliminates the need for a second closing, simplifying the process for the borrower. This loan type is ideal for new construction real estate projects.

FHA 203(k) loan

The FHA 203(k) loan is tailored for the rehabilitation and renovation of existing homes. This loan type is especially beneficial for purchasing fixer-uppers or upgrading your current home. It allows borrowers to include the costs of minor repairs (a minimum of $5,000) or significant renovations in their total loan amount.

The 203(k) program is divided into two options:

• Limited 203(k) for projects under $35,000
• Standard 203(k) for larger-scale renovations

The standard 203(k) loan even requires a HUD-approved consultant to oversee the project, ensuring proper execution and compliance with FHA guidelines. This rehabilitation loan is a powerful tool for transforming an existing home into your dream space​​.

How to get an FHA construction loan

The FHA construction-to-permanent loan basically involves four steps, according to Money Avenue co-founder and president A. Donahue Baker.

“First, you get qualified by an approved lender. Then, your builder and general contractor get qualified for the loan. Next, your home design plans get qualified for the loan. Lastly, you close on the loan and begin the process of building your dream home,” he says.

1. Find the land you’ll build on

When it comes to the land purchase, you have options.

It can be vacant land you already own that’s paid off; land with an existing loan from a bank or private party with the balance to be paid off at closing; or land you wish to place under contract to be paid off at closing.

“The land should not require a teardown of the property or have multiple properties on it,” cautions Richie Duncan, senior loan officer with Nationwide Home Loans Group.

2. Get pre-qualified for financing

Before you can finalize your budget and building plans, you need to get prequalified with a lender. The prequalification process will determine how much you qualify for and what your lender’s borrowing limits are.

“If you don’t have the land and builder chosen yet, your prequalification could expire and market conditions like interest rates increasing could heavily reduce the amount you can borrow,” Duncan notes.

So, you might want to have a contractor selected even before you begin the mortgage process.

But understand you won’t know how much you’re approved to borrow — or even if you qualify — until you’ve spoken with an FHA construction loan-approved lender.

3. Hire a builder and draw up plans

You can begin the process without having yet picked a builder. But the builder you select must be willing to work with the FHA construction loan program (“not every builder will,” says Mushlin).

You’ll want to pick a builder that’s worked with the FHA construction program before, if possible, as this could help the process go smoothly and avoid any major issues.

4. Complete the loan process and begin construction

After your land and builder contracts are agreed to, an appraisal can be ordered to determine the property’s forecasted value based on a completed home.

“During this time, your credit will be evaluated and your land and builder contracts will be underwritten and approved. Your lender will also confirm that homeowners insurance is in place, set up your title, and calculate all final numbers for underwriting,” Duncan says.

“Once the underwriters sign off, the construction team then signs off, the documents are drawn, and you go to closing.”

After the loan closes, construction can begin.

Funds from the loan will be kept in an escrow account, and your contractor will be paid in installments as each construction phase is completed.

FHA construction loan requirements

Several rules apply to FHA construction-to-permanent loans, including requirements for the borrower, the property, and the contractor.

Borrower eligibility

• Down payment of at least 3.5%. This is the minimum for FHA financing
• Credit score of 640 or higher. Technically, you only need a 580 FICO score to qualify with FHA. However, Mushlin says that in his experience, a higher credit score of at least 640 is usually needed for the FHA construction program
• Clean credit history. You must not have experienced bankruptcy in the last two years
• Debt-to-income ratio (DTI) below 43%. That means your monthly debts — including future mortgage payments — don’t take up more than 43% of your monthly pre-tax income
• You will need to verify two years of employment and income. For W-2 borrowers, that means the last 60 days of pay stubs, the last two years of W-2s, and your last two annual tax returns. Self-employed borrowers will need to provide the last two years of full personal and business tax returns as well as all tax schedules involved

In addition, all FHA borrowers are required to pay mortgage insurance premium (MIP), which protects the lender in case of foreclosure.

FHA MIP has an upfront cost equal to 1.75% of the loan amount (which can be rolled into the mortgage) as well as an annual charge typically equal to 0.85% of the loan amount and paid monthly.

MIP is usually required for the life of the loan. However, homeowners can often refinance to cancel mortgage insurance and lower their monthly payments once they have 20% home equity.

Property requirements

• The loan must meet FHA loan limits. Your total loan amount can’t be higher than your county’s maximum loan limit; in 2023, most counties have a max borrowing limit of $
• The property must be eligible. The types of homes eligible to be built include single-family homes, condominium units in approved projects or legal phases, and manufactured homes. The home must be owner-occupied as your primary residence. And, the property must be located in an FHA-approved area
• The property must be inspected. “There is a requirement that inspections be performed by ICC-certified inspectors or a third party who is a registered architect or structural engineer,” says J. Keith Baker, chair of curriculum for Mortgage Banking and Financial Services at Dallas College

Contractor requirements

Finally, the FHA must approve of your chosen licensed contractors, who are required to have needed licensure, liability insurance, and a minimum of two years of experience building homes

You must also receive a new construction warranty from the builder.

Any remaining funds after construction ends must be applied directly toward your loan principal — you can’t keep them as cash-back.

FHA construction loan lenders

Be forewarned: It’s not easy to find FHA construction-to-permanent loans or lenders offering these loans.

“Finding a lender that will process these loans quickly, efficiently, and is staffed with a full team is even rarer,” says Mushlin.

Fortunately, you can visit the US Department of Housing and Urban Development’s (HUD) website to search for FHA lenders, although not all FHA lenders offer FHA construction loans.

The bottom line: If you want an FHA construction loan, you need to be patient and willing to shop around for the right mortgage company.

This can make the process more complicated than a traditional construction loan — but for those who put in the work, there are real benefits to be had.

FHA construction loan interest rates

Expect the interest rate you’ll pay for an FHA construction-to-permanent loan to be higher than for other types of loans. “Typically, borrowers often see rates around 2% to 4% higher [than current mortgage rates],” says Duncan.

By comparison, the rate on a conventional construction loan might be around 1% higher than market rates.

Julie Aragon, CEO and founder of the Julie Aragon Lending Team, says lenders generally view these loans as a greater risk because the home, which ordinarily serves as collateral, does not yet exist.

“Interest rates for these FHA loans can also fluctuate based on the creditworthiness of the borrower and other factors,” she says.

Pros and cons of FHA construction loans

Before deciding on an FHA construction loan, it’s important to weigh the pros and cons. From advantages like lenient credit score requirements and the streamlined process of a one-time close, to drawbacks like compulsory mortgage insurance and restrictions on contractor choice, here’s what you should know about the pros and cons of FHA construction loans.

• Lenient credit score requirements: The FHA construction loan is accommodating for borrowers with lower credit scores, accepting a minimum credit score of 500 with a 10% down payment. For scores of 580 or higher, the down payment requirement drops to 3.5%.
• Simplified one-time close construction loan: FHA offers a one-time close construction loan, reducing the complexity and costs associated with multiple closings typical in traditional mortgage loan processes.
• Versatility in construction projects: These loans support a variety of projects, from new constructions with the FHA construction-to-permanent loan to renovations under the FHA 203(k) program.

“This loan is designed to combat the more costly and cumbersome traditional construction loan program,” says Brandon Mushlin with BuildBuyRefi.com.

“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 outcomes desired to achieve the end result,” Mushlin explains.

Cons

• Mandatory mortgage insurance: All FHA mortgages, including the FHA one-time close construction loan, require both upfront and annual mortgage insurance premiums until the loan is paid in full or refinanced into another loan type.
• Borrowing limits: The FHA sets annual loan limits, which in 2023 cap at $472,030 for most areas, with higher limits in certain high-cost regions.
• Stricter requirements: Compared to other types of loans, FHA construction loans often have more stringent requirements, like specific health and safety conditions in FHA appraisals, which are not typically a concern with conventional loans.
• Requirement for licensed contractor: FHA construction loans mandate the use of a licensed contractor, which can limit flexibility in choosing builders and potentially increase project costs.

FHA construction loan alternatives

There are many different construction loan options available, some supported by federal agencies or local governments and catered to particular qualifying groups. Additionally, private mortgage lenders offer construction loans with potentially more favorable terms for those who meet certain criteria.

• Conventional construction loans: These loans, provided by banks and private lenders, generally require a larger down payment, often above 20%, but can be more cost-effective for borrowers with higher credit scores.
• State and local government programs: These programs provide construction and rehab loans for people with low to moderate incomes, frequently with the help of regional housing authorities or non-profits.
• Fannie Mae and Freddie Mac loans: Fannie Mae provides various financing options for new construction and home renovations, including the HomeStyle Renovation loan. In a similar vein, Freddie Mac provides home improvement loans through the CHOICERenovation program.
• USDA construction loans: These one-time close construction loans, administered by the U.S. Department of Agriculture, help low- to moderate-income borrowers construct homes in qualified rural areas.
• VA construction loans: All active-duty personnel and veterans are eligible for these loans, which come with a guarantee from the Department of Veterans Affairs. VA construction loans have no down payment requirement or mortgage insurance, and they frequently have low interest rates.

FAQ: FHA construction loans

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