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Updated on Wednesday, January 30, 2019
For some homebuyers, their dream home doesn’t yet exist. Rather, they can visualize the home that they want to live in and make plans to build it from the ground up. If you want to turn such a vision into reality, not only will you need a loan to cover the cost of the house, you may also need to come up with financing for the construction of the house. In this scenario, a construction loan may be your ideal solution.
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Construction loans provide funding for the building or renovation of a house, along with the financing for the house. They are typically more difficult to get than a mortgage loan for a house that’s already been built, said Peter Grabel, managing director of Luxury Mortgage Corp. in Stamford, Conn. Many lenders consider construction loans to be riskier than conventional mortgages because borrowers not only need to be able to handle the costs of building the house, they may need to pay for a place to live while the house is being built, Grabel said.
Plus, there is also the chance that something could go wrong during the construction process. “If you purchase a house for a million bucks and you stop making payments, the bank can repossess it and they can sell it,” Grabel said. “When you have a house that’s under construction, it’s kind of worthless until it’s finished.” Because there is more risk involved, construction loans tend to have higher interest rates than conventional mortgages.
Another factor that makes construction loans more complicated than traditional mortgage loans is that many lenders require homebuyers to take out two separate loans — one for the construction of the house and one to finance the mortgage. However, the Federal Housing Administration (FHA) offers options that let homebuyers take care of all of the financing in a single loan. Here’s how those options work:
2 types of FHA construction loans
Construction to Permanent loan
A Construction to Permanent loan covers the cost of building the house, as well as financing for buying the house. One of the greatest advantages of taking out an FHA Construction to Permanent loan is that you only need to be approved for one loan, rather than two. That might not seem like a big deal, but if you have to take out two loans, as some private lenders require, you may have to be approved and pay closing costs twice. FHA Construction to Permanent loans also allow you to reap the benefits of the FHA home loan program, such as lower down payments and less stringent credit requirements.
While Construction to Permanent loans can be a good choice for new construction, a 203(k) loan covers the cost of purchasing a house that needs major improvements and the financing of repairs. A rehabilitation loan can also be used to refinance your current home and make major improvements. One of the greatest advantages of a 203(k) loan is that it lets you roll the costs of repairs into the mortgage. You also can take advantage of other features of the FHA loan program, such as down payments as low as 3.5 percent of the purchase price.
An important distinction to note: 203(k) loans fall under two different categories:
- Standard 203(k) loans cover repair work that costs a minimum of $5,000. However, the property’s total value after the rehabilitation must be within the FHA’s mortgage limit for that area. (You can look up the FHA’s mortgage limit for your area here.) Because the work done with a standard 203(k) loan is typically extensive, you must work with a 203(k) consultant, an inspector who can identify what improvements need to be made and come up with an assessment of how much they will cost. You can find a 203(k) consultant on the website of the U.S. Department of Housing and Urban Development (HUD), or your lender can help you find someone.
- Limited 203(k) loans are ideal if you need less extensive work done. Under the limited 203(k) program, you can finance up to $35,000 in repairs, and you don’t need to work with a 203(k) consultant.
How to apply for an FHA construction loan
If you’re interested in getting an FHA construction loan, you must first find an FHA approved lender.
Lenders consider a number of factors when determining whether you’ll be approved. For instance, to qualify for maximum financing from FHA loans, you’ll need a credit score of at least 580. Lenders will also consider your income, assets and debts.
In the case of a Construction to Permanent loan:
- Applicants must have a contract with a licensed general contractor who will be making the improvements. If the borrower wants to make his or her own improvements, he or she must be a licensed general contractor.
- In order for a property to be eligible, the borrower must purchase the land when the construction loan closes, or have owned the land for no more than six months.
In the case of a 203(k) loan:
- Borrowers must complete repairs within six months of the loan’s closing. However, there may be exceptions depending on how extensive the work is.
Alternatives to FHA construction loans
While FHA construction loans offer a number of advantages, they aren’t your only option for financing new construction or making major renovations. Here are some other ways you can get the funds you need:
- Many private lenders offer construction loans that are not part of the FHA program. Some require homebuyers to take out two separate loans — one that provides money to get the house built and the other to cover the mortgage. Others offer Construction to Permanent loans like those backed by the FHA. Keep in mind that private lenders will have their own set of requirements for borrowers. Because construction loans are considered riskier than traditional mortgage loans, many lenders who offer them require higher credit scores and more of cash cushion than they do for traditional loans, Grabel said.
- If the improvements you will make to the house will lead to energy savings, you may qualify for an Energy Efficient Mortgage, or EEM. These loans are backed by the FHA or the U.S. Department of Veterans Affairs (VA), and they let homebuyers finance the cost of the upgrades or improvements by rolling the fees into the mortgage.
- Another way to finance major improvements to a house you already live in is to take out a home equity line of credit, or HELOC. With a HELOC, you can borrow against the equity in your house to pay for renovations. HELOCs come with a “draw period,” a time during which you can withdraw money as often as you want. However, when the draw period is over, some HELOCs require you to pay the entire balance at once. If you plan to finance expensive renovations, make sure you would be able to pay the loan back once the balance is due. One of the risks of using a HELOC to finance repairs is that if you can’t make the payments, you could lose your house.
Finding the right solution
Building a house from the ground up or making major renovations to an existing house can be complicated. FHA construction loans can make things easier by offering a streamlined financing approach. However, make sure to consider all of your options to come up with the best solution for you.
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