How does an FHA construction loan work?

FHA construction loans are small down payments loans that make it possible for low-to-middle income people to build their dream home.

Pat Howard 1600

Pat Howard

Published April 30, 2019

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If you’re interested in taking out a mortgage to build your dream home, you’ll need a home construction loan. Construction loans are also valuable if you plan on buying and remodeling a fixer-upper home. However, construction loans can be difficult to qualify for if you have low credit or can only afford to put down a small amount.

If you’re struggling to qualify for a private construction loan, your lender may offer loans backed by the Federal Housing Administration (FHA), called FHA construction loans, which accept lower credit scores and down payments than private construction loans.

With FHA construction loans, you only pay closing costs prior to construction, with the mortgage automatically converting to a permanent loan after construction.

However, FHA construction loans have their downsides as well. The closing process can be labor-intensive and long, and you can only use FHA-authorized contractors. But if you can only afford a small down payment and you can land a good rate, an FHA loan may be a good idea.

In this article:

What is an FHA construction loan?

A regular FHA home loan makes it possible for lower- to middle-income homebuyers to qualify with a credit score as low as 580 and a down payment as low as 3.5%. Depending on your lender, FHA loans may also allow for a higher debt-to-income ratio, which measures how well you’re able to repay debt.

An FHA construction loan works similarly for homebuyers interested in building a new home or fixing one up. You can put down a smaller amount and the approval process is easier than a typical construction loan.

But you need a slightly higher credit score — generally anywhere from 620 to 700, depending on your lender — and you have to pay more closing costs than a regular FHA loan.

There are two main types of FHA construction loans:

  • A construction-to-permanent loan which is for homebuyers who want to build a new home.
  • A 203(k) rehabilitation mortgage which is for homebuyers who want to buy a home but need financing to make repairs or renovations.

Construction-to-permanent loan

A construction-to-permanent loan combines a short-term construction loan and a long-term mortgage. That means there is only one application, one closing process, and one loan, so you don’t need to take out a new mortgage once construction is complete.

With a construction-to-permanent loan, after you close on the mortgage prior to construction, the funds go into escrow, and the amounts intended for construction inspections and builder validation fees are distributed at those stages of the home-building process. In order to be eligible for a construction-to-permanent loan, you need to have purchased the land at closing or have owned the land for six months or less at the time you applied.

During the construction phase, you make interest-only monthly payments. Then around 60 days after the final construction inspection when the home is ready to be lived in, you’ll begin making your amortized mortgage payments.

One downside of construction-to-permanent loans is, aside from the high closing costs, the prequalification, application, processing, and underwriting process can drag on longer than a standard mortgage. Additionally, your contractor needs to go through a detailed approval process which can take anywhere from two to 12 weeks. Once all that happens, you need to close before construction on the home can start.

203(k) rehabilitation mortgage

A 203(k) rehabilitation mortgage, also called a rehab loan, is a loan that allows you to finance and make repairs or renovations to a home. Rehab loans make it possible to finance run-down homes that lenders may otherwise refuse to approve for a mortgage.

Rehab loans have many of the same benefits as construction-to-permanent loans: down payments as low as 3.5%, a low credit score threshold for approval, and higher debt-to-income ratios also may be allowed. You also go through underwriting and pay all of your closing costs prior to the construction, or “rehabilitation” phase of the mortgage process.

There are two types of 203(k) mortgages: a standard 203(k) loan and a streamlined 203(k) loan.

Standard 203(k)

Standard 203(k) loans are intended for large-scale structural repairs and renovations exceeding $35,000. At least $5,000 of a standard 203(k) loan must go toward repairs.

With a standard 203(k) loan, its required that your home rehabilitation plan be written up by an FHA-designated consultant before being approved by the FHA. Once the rehabilitation process is complete, you undergo a final inspection before making your regular mortgage payments.

The types of repairs allowed for standard rehab loans are:

  • New construction such as additions
  • Structural repairs
  • Landscaping
  • Repairs exceeding three months
  • Repairs that require detailed architectural mapping and schematics
  • Renovations that don’t start within 30 days of the loan closing, or which require the buyer to be displaced from the home for more than 30 days

Streamlined 203(k)

Streamlined 203(k) loans are for smaller repairs — less than $35,000 but more than $1,000 — and don’t require nearly as much paperwork or oversight as a standard 203(k). Streamlined loans are recommended for cosmetic repairs that don’t involve any structural change or additions to the home, including:

  • Replacing built-in appliances like a water-heater or HVAC system
  • Replacing flooring, windows, and doors
  • Paint jobs
  • Minor roof repairs
  • Weatherization
  • Accessibility improvements for the handicapped or elderly

Qualifying for FHA construction loans

One thing to understand FHA construction loan is they’re a little more difficult to qualify for than regular mortgages. Since the FHA is insuring the entire loan — including the construction and renovations phase — and they have their own building codes and guidelines, you’re facing more examination and scrutiny during the qualification process than if you were taking out a mortgage on an already-built home.

To qualify for an FHA construction loans, you go through the following steps:

  • Before applying, you go through pre-qualification, which is the loan officer’s initial review of your financial information. This gives you a better picture of how much you’ll be able to spend on the project before deciding whether to proceed with the application.
  • Next is the application, where you provide everything from your Social Security number to employment history to tax returns to your income information. From there, you receive a loan estimate.
  • During the application phase, you’ll submit a number of documents. If you’re taking out a construction-to-permanent loan, you’ll need to provide a deed or contract that prove your ownership of the land that the home is being built on. You’ll also need to have contracted with a builder to construct or improve the home. The builder must be a licensed general contractor and you’ll need to provide their information to your lender.
  • Once all the documentation is submitted, you move on to underwriting, which is the process where all of your paperwork is reviewed and its determined whether you have the ability to repay the mortgage. During underwriting, the builder and construction/renovation plans are also reviewed — this is what can drag out the qualification process.
  • Once you’ve passed underwriting, you pay closing costs before the home’s construction or renovation can begin.

Other FHA construction loans

There are a few other kinds of FHA loans that fund home construction and improvements.

Building-on-own-land program

The FHA’s building on own land product is technically part of the 203(b) loan program (a regular FHA loan) and is used to finance the construction of a home on land that’s been owned by the borrower for more than six months.

203(h) loans for disaster victims

A 203(h) disaster loan is available to borrowers in presidentially-declared disaster areas and can be used for the purchase or reconstruction of homes belonging to disaster victims.

Energy-efficient mortgage program

The FHA’s energy efficient mortgage program (EEM) finances energy-efficient home improvement projects and can be added to the borrower's regular FHA loan. In order to qualify, the proposed improvements must be deemed cost-effective based on a home energy assessment.

Weatherization

The FHA’s weatherization loan allows borrowers to finance the cost of eligible energy-related weatherization improvements on top of a base FHA loan. Weatherization improvements may be financed in conjunction with the following loans: 203(b), 203(h), and EEMs.

Solar and wind technologies

The FHA’s solar and wind technologies loan allows borrowers to increase their mortgage amount to fund solar or wind energy renovations to the home. Solar and wind energy improvements can be used in conjunction with the same FHA loan programs as weatherization loans.

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