When you want to build your home from the ground up, you need a different type of financing. Because you have to pay all of the costs on your own, you need temporary financing to help you with those costs. Once the house is built, you then need permanent financing, just like a mortgage you would obtain on a home a builder pays for up front. A home construction loan is not as common as a standard mortgage, which means you might have to shop around a bit to find one. There is one FHA option available for you though.
The Need for a Construction Loan
The FHA construction loan wraps your building loan and your permanent mortgage into one product. You receive the short-term financing necessary to build your home with the permanent financing needed to occupy the home. If you build your own home, rather than purchasing a developer funded home, you will need financing like this. If you hire contractors, have a say in the blueprints, and can customize every aspect of your home, you need a construction loan.
The construction portion of the loan requires only interest payments. In fact, you only pay interest on the disbursed funds each month. Because lenders do not disburse all of the funds right away, you make smaller payments in the beginning, with the larger payments near the end of the loan. The interest only payments end when the building process stops. Once you are able to occupy the property, your loan flips into a standard FHA loan where you pay a fixed interest rate payment comprised of interest and principal for the life of the loan.
The Benefits of the FHA Construction Loan
Securing a construction loan is trickier than a standard loan. First, you must qualify for not one loan, but two loans. The construction portion of the loan is temporary. Most lenders give you a maximum of 12 months to build your home. At the end of the process, the loan becomes due. This means hundreds of thousands of dollars are due all at once. Since you probably do not have that money, you need the permanent financing portion of the construction loan. This is the permanent financing. The FHA construction loan offers this as a one-close option. This is a tremendous benefit to borrowers for several reasons:
- Only pay closing costs one time
- Only qualify for the loan at one time, any future issues will not affect your ability to secure financing
- Use the same lender for the entire process to reduce confusion
If you have a construction loan separate from your permanent financing, you must qualify for both loans. You qualify for the construction loan at the start of the process. You then qualify for permanent financing closer to the closing date of your home. If something drastic changes between that time, you could find yourself without permanent financing. You eliminate this risk when you use the FHA one-time close construction loan.
Qualifying for the FHA Home Construction Loan
FHA loans are known for their easier requirements. However, a home construction loan brings with it a whole new set of risks. Because of this, the FHA loan for new construction is a little stricter than standard FHA loans. The requirements vary by lender, but a general idea of what any lender may expect is as follows:
- Credit scores in the mid 600’s – usually over 680
- Maximum debt ratio of 45% on the back-end (including all monthly debts)
- Bankruptcies must be discharged for at least 2 years
- Foreclosures must be at least 3 years in your past
- Collections must all be paid
- There should not be any judgments or liens against you
However, you are not the only person that must secure approval for the construction loan. Because a lot depends on the quality of the builder, he too must secure approval. After you turn in your loan application, it is the builder’s turn to obtain approval.
The builder applies with the lender much like you do. The builder must show their qualifications, including license and insurance. They must also show their past work history and any relevant experience they have. For example, if you are building a luxurious home, the builder needs experience in this type of home. If he normally builds manufactured homes, for example, he would not qualify. The lender has to be able to trust that the builder can do a quality job in a timely manner in order for the loan to work.
Once the lender approves the builder, they must approve the plans. The builder and/or architect should submit blueprints of the proposed home. Along with the blueprint, the builder must provide the proposed budget and timeline for the work. This way the lender can approve the funds needed to build the home. If there is something the lender does not like, they can negotiate with the builder to get things under their terms.
Lastly, the contractor and lender must agree to a draw schedule. This is when the lender disburses the funds. They do not just hand over thousands of dollars to the builder and hope they do a good job. Instead, they have a predetermined time that they disburse funds. For example, they may disburse 10% of the funds at the start of the project. This helps the builder secure the necessary materials and start building. At predetermine points throughout the building process, the lender will have a professional inspection conducted. This will let the lender know whether the building is on schedule and up to the required specs. If there is something that does not meet the lender’s guidelines, they will not disburse the next scheduled funds.