FHA Construction Loan: A Complete Guide
Finding the perfect home can be challenging. Sometimes, the best way to get into your dream property is to simply build it from the ground up. However, financing new construction isn't as straightforward as buying an existing residence.
With an FHA construction loan, however, you can use one single mortgage to purchase land and construct your home. Once the work is complete, the mortgage automatically converts into long-term financing.
Key Takeaways
FHA construction loans allow you to purchase land and build a home with the mortgage converting into long-term financing once the property is move-in ready.
Eligibility requirements are lower for FHA new construction loans than for most other types of construction financing.
If you already own a suitable parcel of land, you can use your existing equity to cover the down payment requirement.
Not all lenders offer FHA construction-to-permanent loans, with conventional construction loans being far more widely available.
What Is an FHA Construction Loan?
An FHA construction loan – often referred to as an FHA construction-to-permanent loan – is a type of mortgage that allows you to finance both the acquisition of land and the construction of your new home.
Since the Federal Housing Administration insures it, you can often qualify for an FHA construction loan with a lower credit score and smaller down payment than traditional new construction mortgages.
Best of all, once work is complete and your home is move-in ready, there’s no need to apply for long-term financing – the loan automatically transitions into a standard FHA 203(b) mortgage.
How Does an FHA Construction Loan Work?
An FHA one-time construction loan combines short-term construction financing and a long-term permanent mortgage into one convenient package.
While you can use it to build on a parcel you already own, the FHA construction-to-permanent loan allows you to purchase land and finance both the hard and soft costs of building your dream home.
Construction funds are held in an escrow account and released in stages – referred to as draws – throughout the building process as your builder meets established milestones.
During this period, you are typically only required to make interest-only payments on the amount drawn, meaning lower monthly costs until the work is complete. It’s worth noting, however, that interest rates are usually variable while the loan is in the construction phase.
After the building is finished and the home has passed its final inspection and received a certificate of occupancy, your FHA construction loan automatically converts into a standard long-term mortgage.
Unlike traditional construction financing, which requires you to refinance into a permanent mortgage, you do not need to repeat the application and underwriting process with an FHA one-time close construction loan. This also means avoiding paying two sets of closing costs, which can save you thousands of dollars relative to the traditional home-building experience.
Compared to a standard long-term FHA loan, construction loans will typically have higher interest rates, which account for the added risk taken on by the lender. As with most mortgages, buyers with lower credit scores will generally see the largest difference.
The FHA new construction loan is different from rehabilitation loans like the FHA 203(k), which allow you to make additions and improvements to existing properties. FHA construction loans let you build from the ground up. In contrast, renovation loans require you to, at a minimum, maintain the existing foundation of an already-built home.
How to Get an FHA Construction Loan
What does the process look like for getting an FHA construction loan? While it’s a little more complex than applying for an FHA-backed mortgage on an existing home, you can generally break the experience down into five different stages:
1. Find a Lender and Get Pre-Approved
The first step in obtaining an FHA new construction loan is to find an FHA lender that offers these types of mortgages in your area. Not all mortgage companies work with the FHA, and not all who do will offer these types of loans.
Finding a suitable lender can be more challenging in some areas than others. In many cases, prospective borrowers may have more success going through smaller, specialized mortgage companies and local financial institutions that have a more vested interest in working with and building up their local community.
Once you've found a mortgage provider offering FHA construction loans locally, you will need to go through the standard pre-approval process like any other type of residential loan.
2. Get Suitable Land Under Contract
After obtaining pre-approval for an FHA construction loan, the next step is to find a suitable lot to build on and get it under contract. Most parcels where you can legally construct a home are acceptable, although the FHA does set a few basic property requirements:
The land should be accessible by an adequately maintained road
Properties should be free of external nuisances such as a nearby airport or heavy traffic noise
Build sites must be an appropriate distance from any nearby explosion risks, such as petroleum storage facilities or high-pressure transport lines
Note: You can use a suitable lot that you already own for your home build. If you’re using existing land rather than purchasing a site, your equity in the property can count towards your FHA construction loan’s down payment requirement.
3. Find a Qualified Builder/General Contractor
Building a home is a complex process. To ensure borrowers have a safe and secure place to live, the FHA requires an appropriately licensed, insured, and experienced builder or general contractor to complete all new construction.
Your lender will want proof that the company or contractor you're working with has all of the required licensing for the jurisdiction in which the home will be built. They will also need to have liability insurance protecting against any problems that may arise during construction. Additionally, they must have demonstratable experience completing all facets of construction required for your proposed build.
FHA construction-to-permanent loan guidelines also requires that they provide, at a minimum, a one-year warranty against any defects or issues with craftsmanship on the new residence.
The FHA does allow borrowers who are licensed general contractors and otherwise meet the builder requirements to oversee construction on their homes. However, individual lenders may have their own restrictions regarding this policy.
4. Close on the Loan and Begin Construction
Following the standard loan underwriting process and approval of your selected builder and site plan, you will then be cleared to close on your loan, take ownership of the property (if purchasing a lot to build on), and begin construction of your new home.
Your lender will put the project funds into an escrow account and release them as a series of draws as the builder reaches certain agreed-upon milestones. The FHA requires three inspections throughout the building process:
After completion of the footing
After the home has been framed
One final inspection once all the work is finished
You are typically required to make interest-only payments on your FHA construction loan during this period, with the amount due calculated based on how much money has been drawn up until that point, including the total used to purchase land and any funds released to your builder.
5. Complete Construction and Move Into Your New Home
After construction is complete and your home passes its final inspection, you will be issued a certificate of occupancy and allowed to move into your new home. FHA guidelines require you to occupy the property as your primary residence within 60 days of completion.
During this same timeframe – no later than the first of the month following 60 days after passing inspection or being issued a certificate of occupancy – your FHA one-time close construction loan will automatically convert into a standard long-term FHA 203(b) mortgage with amortization based on the terms you’ve agreed upon with your lender.
This means a fixed-rate loan with a 30-year repayment schedule for most borrowers, although other lengths may be available. If you have yet to lock in an interest rate, your long-term rate will be established at this point.
In addition to fixed-rate loans, specific lenders may also offer adjustable-rate options.
FHA Construction Loan Eligibility and Requirements
Obtaining an FHA construction loan requires you to meet minimum FHA eligibility requirements. Because of the mortgage's government backing, these are typically less restrictive than with conventional construction financing.
Keep in mind that while we will outline the minimum loan eligibility requirements established by the FHA, individual lenders are free to set their own more restrictive requirements, referred to as overlays. Lender overlays are more common for FHA new construction loans than your typical purchase mortgage.
Credit Score
Most FHA-backed loans require a minimum credit score of 580. Borrowers with a sizable down payment (or who already own the land they’ll be building on) may be able to get approved with a score of 500.
Down Payment
Most FHA construction loans will require a down payment of at least 3.5%. Borrowers with a credit score below 580 must have at least 10%. If you already own a suitable lot, your existing equity can count towards your down payment requirement.
Property Type
Agency-backed mortgages are only available for your primary residence – you cannot use an FHA new construction loan to build a vacation home or investment property. You can, however, build a residence with up to four individual units as long as you intend to occupy one of them.
Debt-to-Income (DTI) Ratio
Lenders are able to accept a debt-to-income ratio as high as 56.9% for standard FHA loans. However, expect DTI maximums to be lower for construction loans.
Loan Limits
FHA construction loan limits are currently $524,225 for single-unit properties in most parts of the United States. This limit increases with the number of individual units you're building, with a four-unit property having a loan limit of $1,008,300 for most locales.
Properties in designated high-cost areas have limits that range from $1,209,750 for a single-family residence to $2,326,875 for four-unit homes. Alaska, Hawaii, Guam, and the USVI are considered special exception zones with even higher limits.
Stable Employment History
Lenders usually want to see at least two years of stable and steady employment history within the same industry or profession. You are, however, allowed to have worked for different employers and may even be able to be approved with a brief employment gap.
Self-employed borrowers generally face more scrutiny, requiring a minimum of two years of being in business. However, you may be able to qualify with a single year of business ownership if you’ve recently transitioned into self-employment from a related W-2 role.
Mortgage Insurance Premiums (MIP)
All FHA one-time close construction loans have an upfront mortgage insurance premium assessed at 1.75% of the total amount financed. This can be wrapped into your loan or paid as part of your closing costs.
You will also have an annual MIP, split evenly among your monthly payments once your construction loan converts into a long-term mortgage, equaling 0.15% to 0.75% of your current balance. Your actual mortgage insurance premium will be based on your loan amount, length, and down payment.
Closing Costs
While closing costs can vary by lender and location, Most FHA borrowers will pay a rate of between 3% and 6% of the amount borrowed. This includes the upfront mortgage insurance premium, which may or may not be financed into your mortgage.
As the name implies, you are typically responsible for paying these expenses at closing. However, FHA construction loan borrowers already owning the lot they plan to build on may have enough existing equity to wrap their closing costs into their new loan.
Alternative Construction Loan Options
Borrowers looking to finance a new build are not limited to FHA construction loans. There are an assortment of other mortgage options which may be more practical in some circumstances.
Conventional Construction Loan
Conventional construction loans are home-building mortgages not backed by the federal government. More lenders offer conventional construction loans, meaning they are often easier to obtain for qualified applicants.
Since a government agency does not insure conventional construction loans, you can expect slightly more stringent requirements, which include a:
Credit score of at least 620
Down payment of 5% or more
Debt-to-income ratio below 50%
You can apply for conventional construction loans that are both single-close and double-close. A conventional construction-to-permanent mortgage works much like the FHA program in that your loan will transition into long-term financing once the build is complete.
Two-close conventional loans are even easier to find but require you to refinance into a permanent mortgage – and pay two sets of closing costs – once the property is move-in ready.
State and Local Programs
In some areas, state and local government agencies offer their own construction loan programs designed to promote community development and homeownership among buyers who may not qualify for traditional construction financing.
These opportunities vary by location and may include grants and forgivable loans, which can be used as down payment assistance for other construction and permanent mortgages. Check with your state’s housing finance agency (HFA) or county and municipal governments to see what programs may be available to you.
VA Construction Loan
The US Department of Veterans Affairs offers a VA construction loan program to qualifying service members and honorably discharged veterans. VA loans do not typically require a down payment, meaning that you may be able to fund your land acquisition and complete home construction in a single mortgage transaction with little to no money out of pocket.
Like the FHA program, however, not all VA-approved lenders offer construction loans. In practice, you may have an even more difficult time finding a mortgage company that issues this type of financing in your area.
USDA Construction Loan
The USDA construction loan program is designed for low-to-moderate-income borrowers planning to build in USDA-approval rural communities. The program works much like the FHA one-time close construction loan in that you can purchase property and build your home with the loan automatically transforming into a long-term mortgage once work is complete.
Fees associated with a USDA construction loan tend to be lower than with FHA-backed mortgages. Plus, while the FHA requires at least a 3.5% down payment, the USDA will allow you to finance up to 100% of the property acquisition and building costs.
Unlike the FHA, however, the USDA does require applicants to meet maximum household income limits.
Equity From an Existing Property
If you currently own a home and have built up a sizable amount of equity, you may be able to use it to fund your new construction through a cash-out refinance or home equity line of credit (HELOC).
Cash-out refinances are available through both conventional lenders and those working with the FHA. Getting a cash-out refinance involves replacing your existing mortgage with a new larger one, with you receiving the difference as a lump sum of cash at closing. You can qualify for a cash-out refinance even if you own your property outright and have no current mortgage.
HELOCs are another option for tapping into your built-up equity that involves qualifying for a separate, secondary mortgage that exists alongside any current loan you may have. These lines of credit come with higher interest rates than cash-out refinances but usually have lower closing costs. A HELOC allows you to withdraw your equity over time, as needed, rather than as a single lump sum.
Pros and Cons of an FHA Construction Loan
An FHA construction loan can be a practical option for borrowers having difficulty qualifying for more restrictive conventional options. Here, we'll review some of their most prominent pros and cons.
Pros
FHA construction-to-permanent loans only require one closing, meaning that the process is more convenient and streamlined and can save you money by not requiring you to pay closing costs twice.
Since the federal government backs FHA loans, borrowers can qualify with lower credit score requirements, often 580, but sometimes as low as 500. Conventional construction loans require a minimum score of 620.
If you already own the land you plan to build on, you can use any existing equity to cover the FHA’s down payment requirements. In many cases, this could even allow you to wrap your closing costs into your new loan.
Cons
All FHA-insured loans require paying for MIP, including a 1.75% upfront mortgage insurance premium. In most cases, ongoing MIP costs persist for the lifetime of the loan, regardless of how much equity you build.
FHA construction loans generally have lower limits than conventional loans in most cases. While the baseline single-family FHA loan limit is $524,225 in most locales, standard conventional borrowers can be eligible to borrow up to $806,500.
Most applicants – especially those with lower credit scores – can expect to pay higher interest rates on an FHA new construction loan than typical existing home mortgages.
Not all lenders offer FHA-backed mortgages, and only some that do will offer FHA construction-to-permanent loans. Borrowers who meet the requirements of conventional lenders will likely have an easier time finding and obtaining a non-government-backed loan.
Is an FHA Construction Loan Right for You?
FHA construction loans let you build your dream home with a smaller down payment and less stringent eligibility requirements than other types of similar mortgages. However, in some cases, finding a local lender offering this program can take time and effort. Conventional single-close options may be a more practical solution in areas where FHA construction loans are not readily available.
