How To Qualify for and Use USDA Construction Loans
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Summary:
USDA construction loans are government-backed loans that help low-income families finance the purchase of land and the construction of a new home in certain rural parts of the United States. In order to qualify for a USDA construction loan, you need to meet certain requirements, and there are also some advantages and drawbacks you’ll want to consider before applying.
For median-to-lower-income families new to homeownership, financing the purchase of a house may seem like an insurmountable hurdle. Building a home is an even more intimidating task, and finding the right loan to finance such a big project can be a struggle.
Fortunately, you have the option of applying for a USDA construction loan. These loans are designed to help low-income and low-credit families afford the price of land and the construction of a new home. If that sounds too good to be true, don’t worry: the process is simpler than you might think!
In this article, we’ll go over what USDA construction loans offer, how you can qualify for one, and the pros and cons of applying for a loan.
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What is a USDA construction loan?
A USDA construction loan is a type of construction loan issued by the United States Department of Agriculture. It is different from other USDA mortgage loans in that it works as a construction-to-permanent loan: it starts by financing the construction of your home, then becomes a permanent mortgage loan once construction is complete.
While this loan type is backed by the U.S. Department of Agriculture, it can be offered by traditional lenders. Unlike regular USDA loans, which are limited to buying existing homes, USDA construction loans are intended to help families build new homes, as well as cover the cost of buying a piece of land to build the home on.
How do USDA construction loans work?
Lenders offer USDA construction loans through the USDA’s Single-Family Housing Guaranteed Loan Program. This program is designed to help low-to-moderate-income and low-credit families get approved for loans to buy land and build homes in certain eligible rural regions.
While there are a number of benefits to government-backed loans, such as no down payment for qualified recipients, they can be more difficult to get compared to traditional loans, as finding a lender who offers these USDA loans may prove to be a challenge.
Although a USDA construction loan acts as both a construction loan and a mortgage, it is a single-close loan, which means it requires only one payment every month, one promissory note, and one set of closing costs. Once construction of the home is complete, the borrower begins the process of paying off a 30-year fixed-rate mortgage.
What does a USDA construction loan cover?
USDA construction loans can be used to purchase land, build a home, rehabilitate existing homes, and improve upon or relocate homes in certain eligible areas. They can also cover some eligible condominiums and manufactured homes. There is no down payment, and they cover up to 100% financing for the construction of a new home.
The following are some of the other expenses covered by a construction loan:
- Inspection fees
- Builder’s insurance
- Administrative fees
- Building permits
- Design/architectural plans
- Utility/septic costs
- Landscaping costs
How to get approved for a USDA construction loan
Looking for financing to start building a new home? Here’s a step-by-step guide on how to get approved for a USDA construction loan:
1) Meet the USDA construction loan requirements
In order to get approved for a USDA construction loan, you as the borrower first need to meet the following requirements:
- You must have a minimum credit score of 640.
- You must have a debt-to-income ratio of no more than 41%.
- You must not have experienced bankruptcy in the last two years.
- You cannot exceed the USDA income limits.
- Upon completion of the home, you must put any remaining funds toward the loan principal.
Your lender will also check to make sure you have up to two years of satisfactory credit history, no gaps in your monthly income, no pre-existing mortgage loans, and no late or unpaid rent payments.
There are also certain requirements for your new home and the land on which you plan to build it:
- The property must be in a USDA-eligible area.
- The finished home must be your primary residence.
- You must work with a USDA-approved contractor.
- You must receive a new construction warranty from your builder.
2) Hire a USDA-approved contractor
If you meet all of the borrower requirements, your next step is to find a USDA-approved contractor to build your new home (as mentioned above in the property requirements). Contractors must have all of the following to be approved by the USDA:
- All necessary licenses and permits
- A minimum of two years of experience building single-family homes
- A clean record that can pass a background check and a credit check
- A commercial liability insurance policy covering no less than $500,000
3) Find a USDA construction loan lender
Once you’ve hired your contractor, it’s time to find a lender who offers USDA construction loans. Keep in mind that these lenders may be hard to come by depending on where you plan to build your home, so expect this search to take some time. You may end up working with either a private lender or a USDA lender. Either way, make sure to do your research and keep your options open so you can find a lender that works for you!
4) Submit your USDA loan application
Once you’ve completed the above steps, it’s finally time to submit your request for a USDA construction loan! Note that this part can also take some time: because a USDA loan application is more extensive than a traditional loan application, expect to wait 30 to 60 days for your application to be fully reviewed.
If your application is approved, congratulations! You’re now ready to start building your new home!
Pros and cons of a USDA construction loan
Before you apply for financing to build a new home, it’s worth weighing the upsides and downsides of a USDA construction loan. Here are some of the pros and cons of applying for a USDA loan:
Pros of a USDA construction loan
- One monthly payment: A construction-to-permanent loan only requires one payment every month, simplifying the repayment process.
- Single-close loan: You only close once on a USDA construction loan, which means you also only need to pay closing costs once.
- No down payment required: A UDSA construction loan does not require a down payment.
- No private mortgage insurance required: According to Ben Gold, Founder of Recommended Home Buyers, “Unlike other government-backed loans, USDA construction loans do not require private mortgage insurance (PMI), which can save borrowers thousands of dollars over time.”
Cons of a USDA construction loan
- Limited lender options: It may be difficult to find a lender who offers USDA construction loans alongside traditional home loans.
- Lengthy loan process: The loan application, approval process, and closing can all take longer than a traditional mortgage loan.
- Fees: A USDA construction loan is subject to annual guarantee fees based on the loan amount, which is not usually the case with conventional mortgage loans.
- Higher interest rate: Construction loans typically come with higher interest rates than traditional home loans.
Alternatives to USDA construction loans
Maybe you don’t quite meet all the requirements for a USDA construction loan, or maybe you’re simply not sure it’s the right option for you. If that’s the case, here are a few alternatives you may want to consider:
FHA one-time close construction loan
This loan is backed by the Federal Housing Administration (FHA) and is intended to help moderate-to-low-income borrowers and individuals with low credit scores afford a home. The main difference between an FHA loan and a USDA loan is that FHA loans require a 3.5% down payment — although you may need to put up to 10% down if your credit score is below 580.
Conventional one-time close construction loan
If you don’t qualify for government-backed loans, you may be able to get a conventional one-time close construction loan instead. Note, however, that a conventional construction loan requires a better debt-to-income ratio than a standard USDA loan. Also, similar to an FHA loan, a conventional loan typically requires a down payment between 3% and 5%.
All that said, conventional loans have fewer threshold requirements than government-backed loans, giving borrowers more options when choosing a lender to help finance their new home.
VA one-time close construction loan
The Department of Veterans Affairs (VA) is another government agency that offers loan options for financing home construction. These loans are available specifically to current or former members of the military who meet certain additional criteria. Since this is a government-backed loan, it also does not require a down payment, but unlike USDA loans, VA loans usually come with an additional funding fee.
Traditional USDA loan
If you can’t qualify for a construction loan, you may want to consider applying for a standard USDA loan to buy an existing home instead. A traditional USDA loan has the same requirements as a USDA construction loan but does not cover the purchase price of land on which to build a home. In this sense, a standard USDA loan is essentially a conventional home loan that happens to be funded by the U.S. government.
FAQ
Can I use USDA construction loans to buy land?
Yes. USDA construction loans are intended to assist borrowers with buying land as well as building a home, all within a single loan that requires only one closing and a single payment every month.
What lenders offer USDA construction loans?
Most lenders don’t offer USDA loans, which means you may need to search for a while before you find a lender to work with. Government-backed loans tend to have longer and more complicated approval processes, which is why private lenders typically prefer issuing traditional mortgages instead.
What is the average interest rate on a USDA construction loan?
The average interest rate for a USDA loan is around 4% for low-income borrowers. Additionally, there is no maximum loan amount; instead, the amount you receive will likely be based on the average property values in the area you apply to build your home.
Income limits also determine your chance of approval for a USDA loan, but this is not a fixed number. Instead, the limit is based on your area’s median income and the size of your family. This system ensures that no families are subjected to unfair advantages or disadvantages based on their size or location.
What constitutes a “rural area”?
The USDA sets geographical boundaries for construction loans based on the population of an area, its proximity to major cities, and the general public’s access to loans and lines of credit in the region. A region can be considered rural if it meets one of the following three criteria:
- It has 10,000 or fewer residents.
- If it has more than 10,000 residents, it cannot be located in a metropolitan area, and there must be a dearth of mortgage credit options for lower-income families.
- If the area has more than 20,000 but fewer than 35,000 residents, it must have been considered rural at one time in the past, have a scarcity of mortgage credit options, and have lost its rural status only after 1990.
Key Takeaways
- USDA construction loans cover the purchase of land and the construction of a new home, paid off monthly with a single payment.
- A USDA construction loan is a construction-to-permanent loan: it covers the construction of a home, then shifts to a 30-year mortgage loan once completion is complete.
- There is no down payment requirement for a USDA construction loan, but you do need to meet specific criteria in order to qualify for one.
- If you can’t qualify for a USDA construction loan, there are a handful of alternatives to consider, including FHA-backed loans, VA loans, private loans, and traditional USDA loans.
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