FHA Construction Loans: A Complete Guide

Don’t worry if the home you plan to buy doesn’t check every box on your dream home checklist. To make your house more livable or functional, you may have to make renovations. But how will you pay for the updates?

If you’re a Federal Housing Administration (FHA) loan borrower, you have options aside from traditional home improvement or construction loans. One of those options is an FHA construction loan, sometimes called an FHA building loan or an FHA new construction loan.

Here, we’ll cover all the ins and outs of FHA construction loans so you're equipped with the knowledge to help you decide if this type of loan is right for you.

Types Of FHA Construction Loans

There are two types of FHA construction loans, the FHA construction-to-permanent loan and the FHA 203(k) loan. Both serve different purposes, and their processes differ slightly.

How FHA Construction-To-Permanent Loans Work

An FHA construction-to-permanent loan covers purchasing land, paying for construction and funding the loan. It starts as a loan for construction, then converts to a permanent mortgage following construction. Borrowers only pay closing costs once, and rates are typically lower than other types of home improvement loans.

With this loan, you’ll need to find and purchase land to build on. FHA construction loans cannot be used for property near a gas or oil well, an airport or a flood-prone area. Then, once you find an FHA-approved lender and get preapproved, you’ll find a licensed contractor to do the work. The contractor must be licensed and insured. Once your project plan is approved by a lender, you can start construction, so long as building permits are in place.

How FHA 203(k) Rehabilitation Loans Work

FHA 203(k) rehabilitation loans are designed for buying and repairing an existing house rather than building from scratch. There are two types of FHA 203(k) rehab loans: standard and limited. A standard 203(k) loan is for major repairs to make a home habitable. A limited 203(k) loan is for habitable homes that require at least $5,000 in repairs. An FHA-approved consultant is required for standard 203(k) loans, but optional for limited 203(k) loans. The loan you need will depend on the home appraisal and necessary repairs.

Similar to construction-to-permanent loans, you’ll still need to find an FHA-approved lender and get preapproved. You’ll also need to find a licensed and insured contractor, have building permits in place and run the project overview by the lender for approval. 

FHA Construction Loan Requirements

FHA construction loans are a great way to build your dream home, but only if you qualify. Requirements include:

• A credit score of at least 500
• A down payment of at least 3.5% for credit scores 580 and above, or 10% for credit scores 500 and above
• A debt-to-income (DTI) ratio of no more than 50%, or in some cases, above 50%
• Paying an upfront and annual mortgage insurance premium
• Having no delinquencies or defaults on an FHA loan in the last 3 years
• Ensuring your desired loan amount does not exceed FHA loan limits

Pros And Cons Of An FHA Construction Loan

FHA construction loans aren’t for everyone. Depending on your individual situation, they might provide a valuable financial tool toward homeownership, and they might not. Let’s look at some of the pros and cons of FHA construction loans so you can make the choice that’s right for you.

Pros

• Accessibility to borrowers with lower credit: When it comes to buying a house with bad credit, FHA construction loans can be a viable option when others aren’t attainable.
• Ability to buy land, renovate or build from scratch with one loan: Rolling your whole project into one loan instead of multiple creates a streamlined approach to land acquisition and home construction.
• Lower down payment requirements: If you’re short on savings, the low minimum down payment requirements for FHA construction loans can make this loan a good fit.
• Low and fixed interest rates during the construction process: Lower interest rates allow you to pay less for the money you’re borrowing. Fixed interest rates mean you don't have to worry about them going up during the project. FHA construction loans offer both.

Cons

• FHA loan limits: The first thing most people think about when building or buying a house is how much they want to spend. If your budget is on the higher end, an FHA construction loan likely won't work.
• Mortgage insurance premium (MIP): This extra cost can be a downside. However, once you meet certain requirements, you may be able to cancel your FHA MIP.

Alternatives To FHA Building Loans

Potential home buyers can also consider other types of construction loans, including:

• Conventional construction loan: These have stricter qualifying requirements but can be larger and have better terms than FHA construction loans.
• USDA construction loan: Some eligible USDA homes can qualify for a construction loan backed by the United States Department of Agriculture that offers 100% financing.
• VA construction loan: This type of VA loan also offers 100% financing but is limited to active military, veterans and surviving spouses.
• Fannie Mae’s HomeStyle Renovation^® loan: Fannie Mae’s HomeStyle Renovation^® loan is similar to an FHA 203(k) loan but offers lower minimum requirements.
• Freddie Mac’s renovation loans: The CHOICERenovation^® loan and the CHOICEReno eXPress^SM mortgage loan sometimes offer more flexibility, like both fixed- and adjustable-rate mortgages and larger loan limits.
• State and local programs: Additional funding is often available at the state and local level. Be sure to research options in the specific area you want to live.

FAQs On FHA Construction Loans

Let’s look at some of the most frequently asked questions about FHA construction loans.

What credit score do you need for an FHA new construction loan?

You’ll need a credit score of at least 500 for an FHA construction loan. But the higher your credit score, the lower the down payment you’ll need.

Can I build a home with an FHA new construction loan?

Yes, but it needs to be an FHA construction-to-permanent loan that covers land, building and loan closing. You must also meet the financial requirements for FHA loans.

Where can I find an FHA construction loan lender?

Use the HUD’s list of FHA-approved lenders to find a lender in your area. Not all lenders offer these loans, but there are a lot of options no matter where in the country you are looking to build or rehab.

Can I finance the FHA closing costs?

Yes, you can do this by increasing your loan amount so it will cover the closing costs. However, this may result in paying more in interest.

The Bottom Line: FHA Construction Loans Make Building Or Renovating A Home Possible

FHA construction loans can work for many different types of potential homeowners. They aren’t the perfect loan for everyone though. Use what you’ve learned here and keep researching these types of construction loans to see if an FHA construction loan is right for you.

Ready to get building or rehabbing with an FHA loan? Start the mortgage application process today.