FHA Construction Loans: Pros, Cons, and How They Work

Securing financing to build a home from scratch might seem far out of reach. But with an FHA construction loan, you can realize this dream, even if you have less-than-perfect credit and without a large down payment. However, the process is different from that of conventional loans.

Let’s break down how FHA construction loans work, the types available, who qualifies, and whether one might be right for you.

What is an FHA construction loan?

This is a mortgage backed by the Federal Housing Administration (FHA) that finances the cost of building a house or renovating an existing property. It works like a conventional construction loan by providing short-term financing for the construction costs, including land. 

FHA construction loans are available in two types: a construction-to-permanent loan and a 203(k) loan.

FHA construction-to-permanent loan 

Also referred to as a one-time close loan, an FHA construction loan enables you to build a home from scratch and includes the purchase of the land or lot. In short, it combines a construction loan and a traditional mortgage into one closing before the construction starts. Once the home is built, it converts to a regular FHA mortgage.

Example: Let’s say you want to build a $350,000 home, and you’ve found a perfect lot costing $50,000. You'd apply for a $400,000 FHA construction-to-permanent loan that covers the land, building materials, and construction costs.

FHA 203(k) loan

Whether you’ve found a fixer-upper to buy or your current home needs renovation, an FHA 203(k) loan can help you finance the upgrades. There are two FHA 203(k) loan options: standard and limited.

• Standard 203(k) loans: Perfect for major renovations over $35,000. 
• Limited 203(k) loans: For minor repairs and upgrades, up to $35,000.

Example: Let’s say you find a $250,000 home in need of a new kitchen or bathrooms, and the total renovation cost is $50,000. Instead of applying for $250,000, you’d take out a $300,000 standard FHA 203(k) loan.

How does an FHA construction loan work?

FHA construction loans might sound complicated, but how they work is fairly straightforward. Here’s what the process looks like from start to finish.

Choose your land

If you’re building a new home, you’ll have to choose a plot of land or build on land you already own. Make sure the land meets the requirements set by the FHA.

Get preapproved

You’ll need to get preapproved for a construction loan by an FHA lender. During the preapproval process, the lender will thoroughly review your finances and verify your documentation to determine how much you can borrow. This involves checking your credit score, income, pay stubs, tax returns, and bank statements. 

Work with a licensed contractor or builder

You’ll need to work with a licensed contractor or builder that’s been approved by the lender. Ensure that the contractor is familiar with FHA property standards. You can also act as your own builder as long as you’re licensed. 

Your builder must also provide architectural drawings, cost estimates, and the construction timeline. The lender will use this information to evaluate whether the property meets the minimum FHA guidelines. 

Get an appraisal

Next, the lender will order an appraisal that estimates your home’s future value after the construction is complete. This will determine the loan amount that the lender will let you borrow. 

Close on the loan

If the lender approves everything, you’ll sign the paperwork and close on the loan before the construction begins. Keep in mind that you’ll pay closing costs. 

Construction or renovation phase

During the construction, the lender releases the funds in phases as the project meets certain milestones. In each phase, you’ll pay interest on the amount disbursed so far. You don’t start paying the full mortgage amount until construction is complete.

Loan converts to a standard FHA mortgage

Once the home is complete or the renovation work is done, the lender will conduct a final inspection to ensure everything meets FHA’s standards. After that, your construction loan automatically converts into a standard FHA mortgage. 

Going forward, you’ll start making full monthly payments, which include principal, interest, taxes, homeowners insurance, and mortgage insurance.

FHA construction loan requirements

You must meet certain FHA construction loan requirements to qualify. These are similar to standard FHA loan requirements but with a few additions. 

• Credit score: A credit score of at least 580, or as low as 500 if you’re putting down at least 10%.
• Debt-to-income (DTI) ratio : A DTI ratio of no more than 43%, although exceptions may apply.
• Down payment: A 3.5% down payment if you have a credit score of at least 580. But if your score is between 500 and 579, you’ll need to put down 10%.
• Loan limits: The loan amount shouldn’t exceed the FHA loan limits for the year.
• Occupancy: For primary residences only.
• Documentation: Proof of income and employment.
• Mortgage insurance premium (MIP): All FHA borrowers must pay upfront mortgage insurance, typically 1.75% of the loan amount.

In addition to these requirements, FHA construction loans need documentation of the construction or renovation project and the contractor you plan to use. For a standard 203(k) loan, you’ll be assigned a 203(k) consultant to estimate all the remodeling costs.

FHA construction loan vs. conventional construction loan

FHA construction loans and conventional construction loans differ in many ways. For one, FHA loans are government-backed, while conventional loans aren't. Other things that set FHA construction loans apart from conventional construction loans include: 

• Lower credit score requirement: FHA loans accept scores as low as 500, while conventional ones need at least 620.
• Lower down payment: You need to put down at least 3.5% for FHA loans, but most conventional loans require 20%.
• Mortgage insurance: FHA loans require mortgage insurance, which you must pay over the life of the loan. You can avoid private mortgage insurance (PMI) with conventional loans if you put down at least 20%.
• Simplified process: The one-time close option means fewer fees and one round of paperwork.

If you’re weighing other government-backed loans, you may want to explore USDA loans. However, they’re only ideal for low-income buyers in designated rural areas.

Why would you get an FHA construction loan over other options?

An FHA construction loan isn’t for everyone. Here are situations when it may make sense to apply for one:

• You want to build your dream home from scratch.
• You’re buying a fixer-upper and need funds to renovate it.
• You have limited savings for a down payment.
• You want to simplify the entire process by rolling all financing into one loan.

If you’re leaning on help from family and friends, FHA allows home buyers to use gift funds to get 100% assistance on their down payments or closing costs. 

How do closing costs work for FHA construction loans?

Regardless of the construction loan you choose, all mortgages come with closing costs. For FHA construction loans, closing costs typically range from 2–6% of the loan amount. These costs include various fees, such as the FHA funding fee, lender’s fee, and third-party fees.

What happens after construction is complete?

Once the construction or renovation is complete, the loan automatically converts into a traditional FHA mortgage. You’ll start paying monthly mortgage payments over the standard 15- or 30-year term. FHA mortgage insurance remains in place unless you refinance the loan.

Bottom line: FHA construction loans are great if you need a more affordable way to build a new home

An FHA construction loan can help you build your dream home or renovate a fixer-upper, especially if your credit score isn’t in good standing and you don’t have a larger down payment. With the right lender and builder, building or renovating a home with an FHA construction loan can be both doable and affordable.

If you find it difficult to secure an FHA construction loan—or this type of financing doesn’t match your needs—consider alternatives like conventional construction loans, USDA construction loans, VA construction loans, or home equity loans.