The stubbornly ongoing housing supply shortage has gotten many home-hunters thinking: If I can’t find a good one, maybe I should build one. Of course, erecting a custom-built residence is expensive. If you’re intrigued by the thought but aren’t sure if you can afford it, an FHA new construction loan could help make your dream a reality.

One key advantage of an FHA construction loan is that it carries the perks of a traditional FHA loan: namely, more relaxed lending criteria than those of private lenders’ products. That’s especially important in this case, because a construction loan — the sort of financing used for new builds — can be tougher to qualify for and typically requires a higher credit score, a lower debt-to-income ratio and a larger down payment than a conventional mortgage does.

What is an FHA construction loan?

You cannot finance the building of a house with a regular mortgage (because there’s no existing residence to use as collateral). Instead, you use a home construction loan, a short-term method of financing. Typically equipped with a one-year term, these loans cover all the costs of constructing a home, from architect’s fee to certificate of occupancy. Sometimes they can be converted to a long-term mortgage, after the house is built.

An FHA construction loan works similarly: Backed by the Federal Housing Administration, it covers expenses including the purchase of land, building materials, contractor and other labor costs, and permits. It also allows you to roll the costs of building or renovating a home into an FHA mortgage.

Just like a traditional FHA loan, these loans make it possible to build a home with as little as a 3.5 percent cash commitment or a credit score as low as 500.

Types of FHA construction loans

There are actually several types of FHA construction loans.

FHA construction-to-permanent loan

An FHA construction-to-permanent loan finances the ground-up construction of a new home. It combines the features of a conventional short-term construction loan with those of a regular FHA loan, providing access to cash upfront to purchase land and build a home, then converting to a permanent mortgage once the construction is complete.

FHA 203(k) loan

An FHA 203(k) loan, also known as a mortgage rehabilitation loan, offers enough money to cover both the cost of a home and the price of necessary repairs or alterations. It’s used to finance not so much a new build as heavy-duty renovations or remodeling of an existing home, like a fixer-upper. This loan allows you to purchase an existing home and upgrade it, or renovate a home you already own, through a single mortgage (either a fixed-rate loan or an adjustable-rate mortgage).

There are two types of 203(k) loans: the standard 203(k), which is generally for financing larger renovation projects costing $35,000 or more and requires the use of a 203(k) consultant; and the limited 203(k), which covers minor remodeling and non-structural repairs costing up to $35,000. You can work with a 203(k) consultant as you progress through a limited 203(k) project, but it’s not required.

How do FHA construction loans work?

For either type of FHA construction loan, you’ll first need to apply through an FHA-approved lender. You can find a list of qualified lenders through the U.S. Department of Housing and Urban Development (HUD). After the lender determines what you qualify for, you’ll choose a contractor for the project. Your lender will need to approve all of your contractor’s plans before you can close on the loan. After closing, you can begin the construction or renovations.

Note that with any FHA loan, including a construction loan, you must pay mortgage insurance premiums. These include a one-time upfront premium, which is 1.75 percent of the amount of the loan, plus an annual premium that varies (from .45 to 1.05 percent) and can be paid in monthly installments.

How FHA construction-to-permanent loans work

With an FHA construction-to-permanent loan, you obtain both the construction loan and permanent mortgage at the same time. In turn, you only need to close on the loan once. It starts out as a short-term construction loan, and once the construction phase is complete, it kicks over to a mortgage to finance your home.

Before you can proceed with a construction-to-permanent loan, your lender will need to sign off on the contractor you choose. Then, once your contractor has drafted the plans for your project, you’ll need to arrange for an FHA appraisal of your soon-to-be-built property’s future value. Your loan amount and your down payment will be based on that appraisal, and you’ll be put on a draw schedule for the loan based on the different phases of the project. During construction, you might only be required to make interest payments. Once construction is complete, the lender converts your construction loan to a permanent mortgage, usually with a 15- or 30-year term. Then, you make payments on your mortgage just like a regular home loan.

How FHA 203(k) loans work

The standard 203(k) loan is reserved for projects that cost a minimum of $5,000, and usually more than $35,000. It requires you to work with a consultant — you can locate one via HUD’s 203(k) consultant database.

In contrast, there’s no minimum on a limited 203(k) loan, and it’s designed for smaller renovations (less than $35,000). It can’t be used for major repairs, including ones that take more than six months to finish or require you to vacate the home for more than 15 days, or require you to pay the contractor in more than two installments.

FHA construction loan requirements

FHA construction loans have the same standards as standard FHA loans (aka purchase loans), but with a few additional requirements. To qualify for any FHA loan, you must:

• Meet the minimum FICO score for a construction loan of 580 or higher (or at least 500 if putting down 10 percent)
• Have a debt-to-income (DTI) ratio of no more than 43 percent (although there might be some flexibility here)
• Make a down payment of at least 3.5 percent (or at least 10 percent if your credit score is lower than 580) of the new home’s estimated value
• Ensure your desired loan amount does not exceed FHA loan limits

On top of this, the FHA construction loans requirements require you to provide documentation showing you’ll be working with a licensed contractor. For a standard 203(k) loan, you’ll also need to work with an approved 203(k) consultant. In addition, for any kind of construction loan and project, you must be prepared to submit the plans to your lender for review.

Pros and cons of FHA construction loans

Pros

• Accessible to lower-credit borrowers – You could have a credit score as low as 500 and still potentially qualify for an FHA construction loan.
• Smaller down payment – Unlike conventional construction loans that typically require 20 percent or more down, you could get an FHA construction loan with 3.5 percent down (or 10 percent down if your credit score is below 580) of the home’s estimated value.
• All-in-one  – A single FHA construction loan can be used simultaneously buy and substantially renovate a home; or to provide financing for construction of a new build that converts to a long-term mortgage.

Cons

• Limits on loan size – While they have higher credit and down payment requirements, conventional construction loans allow you to borrow a larger sum than an FHA construction loan.
• FHA mortgage insurance – All FHA loans, including FHA construction loans, require the borrower to pay mortgage insurance premiums (MIP).
• More complicated process/oversight – Contractors and builders must be approved, meeting FHA licensing and insurance requirements; standard FHA 203(k) loan-financed projects require a supervisor

Alternatives to an FHA construction loan

There are other types of construction loans— either federally-backed or sponsored by a state or local government — that offer relaxed lending requirements to specific groups that qualify. There are also private construction loans that may offer better terms if you meet the qualifications.

• Conventional construction loan – Conventional construction loans are available through banks and other lenders. They may be harder to obtain than an FHA construction loan, often requiring a down payment of 20 percent or more, but they can cost less if you have a higher credit score.
• State and local programs – New construction and home rehabilitation loans may be available for low- to moderate-income borrowers through the local government, nonprofit organizations or local housing authority.
• Fannie Mae and Freddie Mac construction loans – Fannie Mae offers a few different loan types to help finance new construction and home renovations. These include construction-to-permanent financing for new builds and the HomeStyle Renovation loan for improvements to a home you own or plan to purchase. Freddie Mac’s CHOICERenovation loan also provides financing for renovations.
• USDA construction loan – The U.S. Department of Agriculture administers construction-to-permanent loans to low- to moderate-income borrowers wanting to build a home in an eligible rural area.
• VA construction loans – Military members and veterans can obtain a VA construction loan backed by the U.S. Department of Veterans Affairs. No down payment or mortgage insurance is necessary, and these loans often offer lower interest rates, as well.

Next steps for getting an FHA construction loan

If you’re building a net-new home and want the FHA construction-to-permanent loan, your next steps are to select a piece of land and get preapproved by an FHA-approved lender. After that, you can hire your contractor, who you’ll work with through the remaining phases of the process, including the design planning, appraisal and construction.

If you’re planning a big remodel or buying a home that will need one, you’ll first need to get preapproved for your FHA 203(k) loan. Then, you’ll hire a licensed contractor to complete the renovations, as well as an FHA-approved consultant to supervise the work if you’ve chosen a standard 203(k) loan. Finally, you’ll close on your loan and begin construction.