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Everything You Need to Know About the FHA Construction Loan

Everything You Need to Know About the FHA Construction Loan

December 14, 2020

Financing a new home build can be a frustrating process for experienced and first-time homebuyers alike. One way to lower those stress levels? A Federal Housing Administration (FHA) construction loan, which offers greater flexibility and lower interest rates.

Keep reading to learn:

  • What an FHA construction loan is
  • How to apply for an FHA construction loan

FHA Construction Loan

Unlike traditional home loans, construction loans (also known as self-build loans) can finance various real estate building projects, including homes. Construction loans are often short-term loans meant to pay for development costs before long-term financing.

Most construction loan programs involve a 20% or higher down payment and have higher interest rates. But, for homebuyers who need a lower down payment, the FHA construction loan might be an ideal financing option.

What It Is

The Federal Housing Administration is a government agency that provides mortgage loan insurance for approved lenders. In general, the FHA loan program requires lower down payments and offers lower interest rates.

In addition to mortgages, the FHA also offers construction loans. The FHA construction loan (also known as the FHA One-Time Close Loan) empowers new home builders to finance construction costs and lot purchase with a loan that eventually closes into a permanent loan.

Benefits

Compared to traditional construction loans, FHA loans boast attractive benefits since the government insures them.

First, FHA loans offer 3.5% down payments and only require a minimum credit score of 580. Applicants with lower credit scores can still qualify for the loan with a 10% down payment.

Additionally, the FHA construction loan offers lower interest rates and insurance premiums for lower credit applicants. FHA loans use fixed rates, unlike traditional construction loans, which typically offer variable interest rates.

While the FHA loan caters to low-income buyers, it is not limited to them. Individuals with higher incomes can still use an FHA construction loan for new home builds.

And finally, the FHA construction can be used for various projects, including single-family homes, multi-family homes, and condos.

Alternatives

There are a few government-backed and private financing alternatives to the FHA construction loan program for homebuyers who need more flexible home loan options.

Common choices for low-income buyers include Fannie Mae and Freddie Mac loans and Home Possible mortgages. For qualified borrowers, the VA (United States Department of Veterans Affairs) and USDA (United States Department of Agriculture) loans also provide flexible underwriting.

Alternatively, conventional loans and lender-paid private mortgage insurance are viable options for buyers with a higher credit score and with enough saved for a 20% down payment.

The process to secure an FHA construction loan can become time-consuming, so for those who want a faster option, conventional loans might be a better option.

Who Qualifies for an FHA Construction Loan

As mentioned before, FHA construction loans are not limited to low-income borrowers. However, there are still eligibility requirements that need to be met.

Here are the requirements needed in order to apply for an FHA construction loan:

  • A minimum credit score of 500 (or 580 to secure 3.5% down payment)
  • Verified employment history for the past two years (verify by pay stubs, bank statements, or federal tax returns)
  • The loan must be used for a primary residence
  • Appraisal by an FHA-approved appraiser to ensure the property meets HUD guidelines
  • Front-end debt ratio should be below 31% of the borrower’s gross monthly income
  • Back-end debt ratio should be below 43% of the borrower’s gross monthly income
  • Anyone who has declared bankruptcy must wait for one to two years before applying

Documents and Insurance

FHA new construction loans also require borrowers to provide certification documents and construction specifications.

The required documents depend on two factors: the type of home and stage of construction.

Single and multi-family home builds require building permits, a certificate of occupancy, and a 10-year warranty. A final inspection must also be completed by an FHA inspector or approved local provider.

Alternatively, manufactured housing projects require initial and final inspections by an FHA inspector and initial and final inspections by an architect or engineer. Proposed manufactured housing construction builds also require a 10-year warranty.

How FHA Construction Loans Work

Typically, homebuyers need to complete one application for a parts and labor loan. Then, they complete a separate mortgage application to cover the cost of the loan.

The FHA One-Time Close construction loan simplifies home financing by using a single financing application instead of the traditional two-part process. As a bonus, the one-time close process also reduces total closing costs.

When homebuyers apply for an FHA construction-to-permanent loan, they receive a short-term construction loan that automatically converts into a long-term FHA mortgage loan. So, there is only one application and closing process for both loans.

How to Apply for an FHA Construction Loan

FHA construction loans offer flexible financing options for a variety of new home build projects.

However, the FHA needs to approve the borrower, property, contractor, and project itself. So, the FHA construction loan process can be more time-consuming than a traditional home loan.

If you’re working with homebuyers who are interested in securing an FHA construction loan for a home build, they must follow this process:

1. Find a Lender

Although FHA loans are insured by the government, the loan is provided by FHA-approved lenders. HUD.gov provides a list of lenders.

2. Check Eligibility and Set a Budget

Homebuyers must meet the minimum credit score requirements (500 for a 10% down payment or 580 for a 3.5% down payment). They also need to verify employment or stable income for the past two years.

If they meet those minimum requirements, then they can calculate the total budget using down payment percentage and guidelines for front and back-end debt-to-income ratio.

Alternatively, if they already own the property, all they need to do is to see if the construction costs meet eligibility requirements.

3. Find a Property

If the homebuyers meet the eligibility requirements and don’t have a property selected, they’ll need to choose the land.

Keep in mind properties might be ineligible if they are:

  • Close to a gas or oil well
  • Near an airport
  • Located in a flood-prone area

Homebuyers that don’t already own the land can use the FHA loan to purchase it.

4. Select a Contractor

Before drawing up plans and certification documents, homebuyers need to find a general contractor. All contractors must be approved by the lender.

In order to be approved as a contractor, you must be a fully licensed contractor. Make sure you’re registered with your local Builders Association so homebuyers interested in an FHA One-Time Close loan can find your information.

5. Submit Documents for Approval

Before homebuyers can close on the loan, the lender must also approve the project. You’ll work with the homeowners to establish the details of the project.

As the contractor, you’ll usually draw up all required documents and submit them directly to the lender.

The lender may also order an appraisal of the building and materials before giving final approval.

6. Close on the Loan

After the lender has approved the project and provided an appraisal value, homebuyers can close on the loan. Assuming the loan amount covers the appraisal value, closing is simple. However, if the appraisal value exceeds the loan amount, you may need to alter your construction plans accordingly.

Let’s Wrap It Up: What Is an FHA Construction Loan and How to Apply for One

To secure financing for a new home or construction project can be an intimidating process, especially for first-time homebuyers.

Whichever route a borrower chooses, it’s essential to learn about the available home loan options before making a significant financial commitment.

For homebuyers looking for flexible and affordable financing options, the FHA construction loan offers lower down payments and interest rates.

Qualifying borrowers willing to go through the approval process may find the FHA construction loan is the best choice for financing their dream home.

This is a guest post by Maddy Osman, a contributor at Hourly. Hourly is a people platform that helps small businesses save time and money by seamlessly connecting the dots between workers’ compensation insurance, time cards and payroll.

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