What is an FHA Construction Loan?

An FHA construction loan is a home loan sponsored by the Federal Housing Administration (FHA) that is used for the construction or renovation of a home. There are two types of FHA construction loans, one-time construction loans, and FHA 203K rehab loans. One-time construction loans are for borrowers who are constructing a brand new home. FHA 203K rehab loans are for renovating or improving an existing home. FHA construction loans work in a similar way as other FHA loans: by insuring the loan, the FHA agrees to pay the lender if the borrower defaults on the loan, which lowers the risk of loss for the lender. The FHA’s insurance allows the lender to offer more favorable terms than they would be able to for a conventional loan.

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Rates (%)

Rates are sometimes expressed as a straight measurement of the interest rates and sometimes expressed as an annual percentage rate (APR) which combines the interest rates with all the fees you will pay averaged out over the whole term of the loan. While APRs give you a complete picture of the cost of your loan, it is important to look at both measurements as together they will give you an idea of how your loan is structured. Rates for FHA construction loans tend to be lower than conventional construction loans, due to the FHA guarantee making the loan more secure. However, most construction loans have significantly higher interest rates (expect around 1% more per year) than home loans that are for the sake of purchasing a home. This is in part due to the relative uncertainty of both the cost and the value of brand new homes or extensive renovations. In addition to the higher interest rates, construction loans usually come with additional fees. In the case of a 203k loan, there is a supplemental origination fee, which is whichever is larger of 1.5% or $350.

Loan Requirements

The FHA sets the minimum credit requirement for one-time construction loans at 620, but since the housing bubble burst in 2008, most lenders have been asking for a significantly higher credit standard, usually at least 680. Newly constructed homes, particularly those constructed by contractors for a singular homeowner, have a lot more unknowns, both regarding the final value and regarding unexpected costs during construction. The home needs to be constructed as the primary residence of the borrower. The land the home is built on needs to have been purchased less than six months before filing for the loan. FHA 203k loans usually require a credit score of 620 or higher. The credit requirements tend to be lower than most one-time construction loans and lower than most conventional home loans, but still higher than FHA loans that are used for purchasing new homes. This is because there are so many more variables and unknowns for construction loans than with conventional loans, which make them higher risk for the lender. FHA 203k loans have some restrictions on the type of project that they can be used on. They cannot be used on a home larger than a four-family home. They cannot be used in a home that is less than a year old. They can be used on a home that has been torn down, only if the new home uses some of the previous foundations. You can also use the funds from an FHA 203k loan to move home to a new location. 

Both types of FHA construction loans require a lot more paperwork than the average home loan. The added paperwork makes FHA construction loans more time-consuming, not just for the paperwork you do, but also waiting for contractors, the FHA and lenders to complete their paperwork. If the construction work you need to do is time sensitive than FHA construction loans may not be the best fit for you. All work paid for must be done by licensed contractors. By the FHA’s standards if the homeowner is a licensed contractor could do the work, but this is more of a technicality as virtually no lender allows for this. As with all FHA loans, FHA Constructions Loans require a 3.5% down payment, which can be made by the borrower or by an outside party as a gift.

FHA One-Time Construction Loan

Otherwise known as a “construction to permanent mortgage,” a one-time construction loan is a type of home loan for purchasing and constructing a home on it. One-time construction loans differ from other construction loans because with one loan you can pay for both the land and the costs of building a home on that land. Since it is only one loan, borrowers have significant savings since they do only need to pay one closing fee. The paperwork for FHA one-time construction loans can be quite extensive. A licensed contractor must do all of the work. The funds from an FHA one-time construction loan are set aside once the loan is closed, but disbursed throughout the process. A final inspection of the home is required, to make sure it meets all of the FHA housing standards. While FHA one-time construction loans do still exist, they have become much more of a rarity after the housing collapse of 2008. Most new houses are made by developers and sold to homeowners along with the land it is built on (using a conventional home loan or an FHA home loan). FHA one-time construction loans are used when an individual buys a plot of land and build a home on it; typically a lender trusts a developer’s sense of the value of a piece of real estate more than an individual’s. 

If you’re thinking an FHA construction loan is what you need and you’d like more information, there are lots of sources online, and talking to an expert is a great way to get the info you need to make the best borrowing choice for your finances. Finding the right loan can be a lot of work, but it’s a process that will pay off big time.

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