Whether you’re building your own home or buying a fixer-upper that needs a significant amount of work, the costs and stress of applying for a construction loan and a permanent mortgage loan can be overwhelming.
There’s a way to finance situations like these, though, without having to take out multiple loans. An FHA construction loan can help you to fund the home of your dreams or gut the kitchen, upgrade bathrooms, and shore up the foundation in your fixer-upper.
But while these types of loans are a great way to resolve issues with funding when you’re building or buying a home in need of repair, they won’t be the right fit for every buyer. You need to know what you’re getting into with FHA construction loans before you sign on the dotted line.
What is an FHA construction loan?
FHA construction loans are designed so that you can roll the costs of either building a home or renovating one into a single mortgage loan product. Even better? FHA construction loans come with lower credit requirements, which makes qualifying for them an easier task.
These loans also require less money upfront. Like all FHA loans, FHA construction loans are insured by the Federal Housing Administration and require a down payment of just 3.5% of the final purchase price plus the cost of your renovations or construction costs.
Let’s say you’re buying a fixer-upper for $150,000 and you expect to spend $40,000 on construction costs for a total cost of $190,000. With a down payment of just 3.5%, you’d only need to come up with $6,650.
When you are building a new home, you can use an FHA construction loan to cover the costs of buying a lot and the construction costs involved with building your residence, all in one loan.
If you are buying an existing home that you want to renovate, an FHA construction loan will cover the costs of buying the home and renovating it, again all in one loan.
Types of FHA construction loans
There are two main types of FHA construction loans — construction-to-permanent and FHA-insured construction loans.
You can apply for an FHA construction-to-permanent loan when building a new home. These loans are a combination of a short-term construction loan and a long-term FHA loan. The construction-to-permanent loan eliminates the need for two closings. This saves you both money and time. You won’t have to pay two sets of closing costs, and you won’t have to apply for two different loans, either.
When you first close one of these FHA loans with a lender, it will act like a temporary construction loan. Your contractors will take draws, which are periodic payments, from this construction loan while building your home. Your construction loan will cover these payments until your home is built.
Once the home is built, the loan converts to a standard FHA mortgage, usually with a term of 15 or 30 years. You then make regular monthly payments, with interest, to your mortgage lender to pay off this loan.
The second type of FHA-insured construction loan, the FHA 203(k) rehabilitation loan, is used by borrowers who want to buy a home that needs costly repairs. Let’s say the home you are buying costs $150,000 but it requires $40,000 worth of repairs. You’d take out a single home loan that would cover the cost of buying the home and renovating it.
How much you take out depends on your down payment. Say you put down $10,000 for the above home, which is more than the 3.5% you’re required to put down. You’d then borrow $180,000, which breaks down to $140,000 for the home purchase (minus the $10,000 down payment) plus $40,000 for the renovations.
There are two types of FHA 203(k) loans. Limited 203(k) loans are designed for remodeling projects that cost $35,000 or less. The standard 203(k) loan is for renovations that cost more than that. You can use the proceeds from these loans to cover any renovation project.
How to get an FHA construction loan
You’ll work with a private lender to apply for either type of FHA construction loan. The FHA insures the loans, but it doesn’t originate them. Fortunately, most mortgage lenders will offer FHA construction loans.
Lenders will check your credit score, debt levels and employment status before approving you for an FHA construction loan. You’ll need a minimum FICO credit score of 580 to qualify for an FHA construction loan with a down payment of 3.5%. You’ll need a minimum credit score of 500 to qualify for one of these loans with a down payment of 10%.
Lenders will also want to verify your income before approving you for one of these loans. You’ll need to provide them with copies of your most recent paycheck stubs, W-2s, tax returns and bank account statements.
There are some additional steps with FHA construction loans. If you are taking out an FHA 203(k) loan, you’ll need to work with an approved contractor to estimate the costs of your renovations before you apply for the loan.
With an FHA construction-to-permanent loan, you’ll also need to work with a licensed contractor or builder and provide estimates of how much it will cost to build your home. Your lender will need to approve your contractor and your building plans.
Benefits of an FHA construction loan
An FHA construction loan is a good choice if you’re looking for a lower down payment. If your credit score is at least 580 — not a particularly difficult score to achieve — you’ll only need a down payment of 3.5%. That makes it easier to come up with the cash to close your loan.
FHA construction loans are also streamlined. You won’t have to apply for two loans — one for a construction loan and the other for a traditional mortgage — if you are building your own house.
If you are renovating a home, an FHA 203(k) loan makes it far easier to come up with the dollars needed to gut or rehab an aging home. This allows you to purchase a less expensive fixer-upper in a neighborhood that otherwise might be out of your price range.