The FHA loan isn’t just for first-time homebuyers. If you want to build a home from scratch, the FHA offers a program for you too. It has the same great characteristics of the standard FHA mortgage. The difference is how you receive the funds and how the lender handles the process.
The FHA mortgage to build a house is two loans in one. You receive a temporary loan during the construction phase. Once the home is complete, the loan transfers into a permanent mortgage. All of this is done under one closing.
The Advantage of the FHA Single Close Loan
The main benefit of the FHA construction loan is that you only have one closing. All the money you need to build the home is in the one loan. This eliminates the need to secure temporary financing and then refinance it into a permanent loan down the road. Generally, you only have to make interest only payments during the construction phase of the project. Once the home is complete and the financing permanent, you make principal and interest payments, just like a standard FHA loan.
With one closing and one loan, you pay fewer fees. You also deal with fewer administrative issues. The FHA makes the process as seamless as their standard loan. The tradeoff for the convenience, however, is a higher interest rate. Because it’s an FHA program, the rate isn’t too high. However, it’s higher than the standard FHA loan rates. Of course, you can shop around to find the best rate for your situation.
Closing Before the Construction Starts
A unique aspect of the FHA single close loan is the closing date. Normally, you’d close on your loan after the home is complete. When you use a builder to create your home, this is the case. The builder pays for the materials and labor to build the home. The builder then gets reimbursed when you close on your home loan and it funds. The closing agent disburses the funds directly to the builder.
When you build your own home, you need the funds to purchase the materials and manage the labor. The FHA single close loan closes before this process begins. At the closing, you’ll receive a portion of the necessary proceeds. The remaining funds get placed in an escrow account for disbursement throughout the process.
Prior to the FHA loan for building a new home, you had to qualify for two loans – one for building and the other for the completed home. The one-close loan allows you to qualify once. That helps not only the ability to get a mortgage, but also your costs. Closing on two loans means paying closing costs twice. With the single loan, you save money in the long run.
Same Low Down Payment
Most construction-to-permanent loans require borrowers to put down between 10% and 20% for a down payment. The single-close FHA loan, however, only requires the same 3.5% down payment as any other FHA mortgage.
One aspect that may put a wrench in things, however, is the lender has a say in what builder you use. You do the shopping for the builder and work out the details. However, the lender has the final say. The lender and the builder must have some type of relationship during the process. The lender disburses the funds directly to the builder during the process.
The lender will look for certain characteristics in the builder. It’s best if you talk to your lender before choosing a builder so you know what they require. The builder will need to provide the lender with specific documents including:
- Tax returns showing their income and expenses
- A P&L statement for the current year
- Required licenses
- Proper insurance
These are the minimum requirements. Remember, each lender can add their own requirements, though. Again, talking to your lender ahead of time can help you avoid making serious mistakes when choosing your builder.
It’s also very important that you have a good relationship with the builder too. You’ll have a relationship with this person/company for the next 6 to 12 months. They also hold the key to the final outcome of your home. Choosing someone with the same vision and work ethic as you can help you get your desired results.
Keeping a Contingency Fund
The lender will likely require you to keep a contingency fund. This is like an “emergency fund.” No one can predict how the building process will go. What if something bad happens? Where will the money come from? Building a contingency fund into your budget will help prevent a financial crisis during the process. The money sits in the escrow account with the other funds. If you don’t need the money after the home is complete, the lender will apply the extra funds to the principal of your loan.
Building a home with an FHA loan is possible. It is a much more in-depth process than a standard FHA mortgage. You get the same flexible guidelines, but you will have to do more work to complete the process. With due diligence and the right builder/lender combination, building your own home can be a great success.