Getting an FHA Construction Loan
Federal Housing Administration-backed mortgages have long been a popular option for prospective homebuyers due to their low credit score and down payment requirements. But you may not know that the FHA also insures mortgages for homebuyers seeking to build a house of their own or buy a fixer-upper that may need a lot of TLC.
An FHA loan isn’t the only path to that new-home scent — read here for more information about the different types of home construction loans available through private lenders — nor is it the only way to make repairs or renovations. But the advantage of an FHA construction loan is the ease that comes with an all-in-one loan versus separate construction and mortgage loans.
In this article, we describe the specific requirements for an FHA construction loan and a few alternatives you may want to consider instead.
What is an FHA construction loan?
FHA construction loans come in two flavors:
- A construction to permanent loan is designed to help homebuyers build and own a home.
- A 203(k) rehabilitation mortgage is intended to help homebuyers not only purchase a house but also finance any necessary repairs or modernization. It may also be used for homeowners to refinance an existing loan in order to make improvements on their home.
The significant difference between the two loans is that the first is designed for the building of a brand-new home while the second is for rehabilitating an existing one.
Construction to permanent
The construction to permanent mortgage combines aspects of both a construction loan and a long-term traditional mortgage into a single loan. Before a borrower can apply for the loan, however, they must meet several requirements, including:
- The borrower must contract with a licensed general contractor. In some cases, a borrower can fill the role of the contractor if they are licensed as a general contractor.
- The borrower should have purchased the land by the time the construction loan closed or owned it for six months or less.
The advantages of a construction to permanent loan include a one-time mortgage closing prior to the start of construction, rather than closing on a construction loan and mortgage loan separately through a private lender. This eliminates the need to go through the approval process two times and pay closing costs twice. Private lenders also offer construction to permanent loans in addition to two-time-close loans, but FHA new construction loans only come in one stripe.
203(k) rehabilitation mortgage
There are two types of 203(k) mortgages:
- Standard – This is generally intended for larger remodeling and repair work with a minimum cost of $5,000. Since the program is intended for more costly improvements, a 203(k) consultant has to assess the improvements before the mortgage is approved.
- Limited – This mortgage is intended for smaller repairs and remodeling work. The total repair costs cannot exceed $35,000. Given the less costly nature of the repairs, there is no need to have a 203(k) consultant involved. There is also no minimum rehabilitation cost.
Homeowners and buyers hoping to rehabilitate a home can find a 203(k) consultant using the search function on the HUD website. This allows shoppers to search by name, city and state. However, you can also work through your lender to find a consultant who will assess your improvements and verify their costs.
For buyers, using a 203(k) rehabilitation loan may be preferable to personal savings to fund what can be costly upgrades to a home.
How to apply for an FHA construction loan
HUD itself does not extend direct loans to borrowers. Instead, to either apply for a construction to permanent mortgage or a 203(k) rehabilitation mortgage, you need to contact an FHA-approved lender.
A lender will most likely need to know:
- Personal information, such as age and Social Security number.
- Credit score and history — a credit score of at least 580 qualifies borrowers for maximum financing, and a smaller down payment, but it’s considered along other factors such as a home’s appraised value, the adjusted as-is value and nationwide mortgage limits.
- Information on the type of property and its location, in the case of a 203(k) rehabilitation mortgage.
Borrowers should work closely with their lender to ensure that they meet all of the appropriate criteria.
Alternatives to FHA loans for new construction
While the federal government provides support for rehabilitation and construction through the FHA, it’s also possible to get a construction loan from a private lender. It’s important to keep in mind that it’s generally more difficult to get approved for a construction loan, and interest rates are typically high. And of course, it’s more expensive to buy a brand-new house than an existing one — in May, the median existing home price was $264,800, according to the National Association of Realtors, while the median new home price was $313,000, according to Census data.
Alternatives to a 203(k) rehabilitation mortgage
And if you’re looking to make repairs to a house you have your eye on — or already own — there are alternatives for that, too, including:
- Energy Efficient Mortgage: If the upgrades you’re making are related to making your home more energy efficient, then an energy efficient mortgage can be applied for when buying, refinancing or remodeling a house.
For buyers, applying for an energy efficient mortgage may lead to a larger mortgage that includes funds that cover energy efficient improvements. For those refinancing and remodeling, the amount of the loan can be increased to cover upgrades related to making the house more energy efficient.
Before an energy efficient mortgage is approved, a home must first be assessed to determine what energy saving improvements it qualifies for that will be funded by the loan.
- Home equity line of credit (HELOC): A HELOC is a common way of funding home improvement projects. However, different plans have different repayment options. Some may require that you pay back a portion of the principal along with interest, while other plans only require interest repayments during the life of the plan.
Like a 203(k) rehabilitation mortgage, a HELOC — or a home equity loan, for that matter — comes with closing costs. A HELOC uses a home as collateral to extend credit to homeowners. You must have equity in your home to qualify for this type of financing.
Lenders look at income, debts and financial obligations when determining how much credit you’re eligible for. In most cases, you can borrow up to your approved credit limit at any time.
While the energy efficient mortgage can be applied when buying a home or refinancing it, a HELOC is only available after buyers have already made payments on their home.
The bottom line
A borrower hoping to either build or rehabilitate a home has several options available to them from both private lenders and mortgages backed by the FHA. The latter can be used to finance the construction and long-term ownership of a home or rehabilitating an existing one. If you do pursue one of these programs, be sure you understand any necessary requirements for you and the property.
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