USDA Construction Loans: Process & Requirements
What You Should Know
- Allows you to buy land, build a home, and refinance into a 30-year fixed rate.
- You must purchase property in a rural area. Typically with a population below 20,000.
- There are maximum income and loan size requirements.
- 0% down payment allowed.
A USDA construction loan is a mortgage program offered by the U.S. Department of Agriculture (USDA). The purpose is to finance affordable housing in eligible rural areas. A primary benefit is the ability to build a home from the ground up with a 0% down payment.
Once the construction is done, the mortgage will transition into a standard, 30-year fixed rate USDA loan. As a result, there is a seamless transition from building to mortgaging the home of your dreams. However, USDA loans have many nuances, such as an income limit.
This guide will walk you through the loan, requirements, and the process of getting one. The article finishes with alternatives if you decide it's not for you. Continue reading to become an expert in USDA construction loans.
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What is a USDA Construction Loan?
You can think of a USDA construction loan as a combination between a USDA loan and a construction loan. A conventional construction loan allows you to finance the cost of building a home throughout the United States. Some construction loans will automatically transition to standard mortgages when construction is completed. This is known as a USDA construction to permanent loan (C2P).
However, these loans often have tough credit score and down payment requirements making them unattainable for most Americans. As a result, the U.S. Department of Agriculture has made this lending product available to rural homeowners. They do this by guaranteeing the loan to convince more rural lending. USDA backs the loan, which provides lenders with less home foreclosure risk. Lenders can then offer more accessible requirements such as no down payment.
You can think of a conventional construction loan as the foundation of this product. USDA then layers in features and requirements designed to incentivize rural homeownership.
A construction loan is a type of mortgage created to help you build a home. It typically covers the cost of buying land and building on it. For example, a construction loan will cover building materials, permits, contractor labor, and more expenses.
To qualify, you will need to show your lender the building plans. They want to ensure the project will be completed in full. Once approved, you typically have one year to build the home. Extensions usually come with fees. Your builder will be paid in multiple installments, known as draws.
They will receive a draw each time a milestone is accomplished and inspected. For example, your builder could receive a draw for completing the foundation, framing, plumbing, etc. You will likely only need to make interest-only payments during the construction phase. However, the monthly payment will increase with each draw.
If you chose a construction-to-permanent (C2P) loan, your construction loan would automatically transfer to a standard mortgage upon completion. This means your balance will move to a 30-year fixed-rate mortgage. You will then need to make monthly mortgage payments of principal and interest.
If you didn't receive a C2P loan, you would need to apply for a mortgage again. This means qualifying for a new mortgage and undergoing the underwriting process again. Additionally, you will need to pay another set of mortgage closing costs. However, you can often receive lower mortgage rates without a C2P loan.
The USDA loan is the second component of this product. It's a type of mortgage available to low and moderate-income homeowners in eligible rural areas. The USDA defines these areas as having a population of 20,000 or fewer.
To qualify, you must meet credit score and regional income requirements. Additionally, the USDA has a maximum loan limit which caps the amount you can borrow. The limit is based on median home prices in your area and family size.
USDA loans have many benefits, such as low interest rates, no down payment, and more flexible credit score requirements. However, there are some drawbacks, such as income and property restrictions.
Tip: USDA Fees
To help offset the cost of this program, USDA charges a guarantee fee. While both fees are likely included with your payments, they are something to be aware of:
- 1% one-time guarantee fee
- 0.35% annual fee
USDA Construction Loan
Now that you understand the two components let's put them together. A USDA construction loan is a product available to rural homeowners who want to build a home. It combines a construction loan and a USDA loan, providing more accessible financing than a conventional construction loan.
To qualify, you must meet the eligibility requirements for both programs. This includes income, credit score, and maximum loan limit restrictions. Additionally, you will need to show your lender building plans to ensure the project is completed in full. The complete requirements are explained in more detail below.
Once approved, you will have one year to build the home. This can be done through a C2P loan or a traditional construction loan refinanced into a new USDA loan.
USDA Construction Loan Requirements
As mentioned previously, this lending product combines the requirements of a conventional construction loan with USDA criteria. While the loan is more financially accessible than a construction loan, there are more criteria.
There are three general requirement categories: personal, property, and construction. Additionally, there are requirements on how you can spend the money. This section will dive into each category and thoroughly explain all the standards.
The USDA must also approve your chosen contractor. In general, your contractor must pass the specific criteria.
USDA Construction Loan Rates
USDA construction loans are a combination of three separate loans; a land loan, a construction loan, and a 30-year USDA loan. Bundling the three loans together results in a higher interest rate than you could get for each loan individually.
However, the bundled loan only has one set of mortgage closing costs. Additionally, there is less risk of not qualifying for another loan. You can think of the higher rate as the cost of convenience and ease of mind.
Lenders also charge higher rates because of the significant time it takes to underwrite a USDA construction loan. For this reason, not many lenders offer this lending product. However, it's encouraged that you shop around to find the best available rate.
USDA Construction Loan Lenders
The largest downside of USDA construction loans is the lack of available lenders. As previously mentioned, this is due to the significant amount of time it takes for lenders to coordinate with the U.S. Department of Agriculture, a builder, and yourself. Oftentimes, lenders prefer to focus on originating conventional loans. However, you may have luck by visiting their page on USDA-approved lenders in your area.
Least Popular USDA Loan Regions
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USDA Construction Loan Process
You should now understand whether you want a USDA construction loan and the requirements. If you decide it's the perfect loan to build a country-side home, this section will explain the process of getting a loan. Once you've met all requirements, it's a straightforward process.
1. Find a USDA Construction Builder
The first step is to find a USDA-approved builder. You must submit a construction plan to your chosen lender to receive financing. The requirements section above highlights builder criteria.
2. Apply for a Loan and Get Approved
After you've found a USDA-approved builder, the next step is to apply for a loan. The application is similar to any other mortgage underwriting process. You'll need to provide documentation of your income, employment, debts, and assets. The lender will also order a credit report. They will use all this information to determine if you're eligible for the USDA construction loan and how much they're willing to lend you.
3. Once You're Approved
If approved, the lender will provide you with a loan estimate. This document will outline the terms of your loan, including the interest rate, monthly payment, closing costs, and more. It's important to review this document carefully before you decide to move forward with the loan.
4. Closing on the Loan
If you decide to proceed with the loan, you'll work with your builder and lender to schedule a closing date. You'll sign all the necessary paperwork at closing and pay any remaining fees. Once everything is finalized, your builder will start constructing your new home.
USDA Construction Loan Alternatives
Many options are available if you decide a USDA construction loan is unsuitable. USDA loans are created to help low to mid-income Americans buy or build homes in rural areas. If you want to develop a home in a non-rural area with a low down payment, then a VA or FHA construction loan could be right for you. If you want to buy and renovate a home, then the Fannie Mae HomeReady or FHA 203(k) could be your best option.
If you don't qualify for any of these options, then a conventional construction loan may be your choice. However, this option often requires a larger down payment than USDA and government-backed loans. If you have a primary residence with home equity, then you can use a home equity loan.
|Purpose||Minimum Down Payment||Credit Score Requirements|
|USDA Construction Loan||Construction||0%||640+|
|FHA Construction Loan||Construction||3.5%||580+|
|VA Construction Loan||Construction||0%||580+|
|Conventional Construction Loan||Construction||20%||680+|
|Fannie Mae Homestyle||Renovation||5%||680+|
|Home Equity Loans||Anything||0% (85% Max LTV)||620+|
FHA Construction Loan
- Minimum Down Payment: 3.5%
- Credit Score Requirement: 580+
This program allows you to build a home in non-rural areas with a low down payment. There are also lower credit score qualifications. All construction costs are included in the loan. If you select an FHA construction to permanent loan, your balance will automatically transition to a regular FHA mortgage upon construction completion.
The downsides of this loan include many qualification criteria and a maximum mortgage limit. In 2022, the baseline FHA mortgage limit was $420,680. However, this amount changes by region and the number of units you build. A four-unit house will have a larger limit than a two-unit one.
VA Construction Loan
- Minimum Down Payment: 0%
- Credit Score Requirement: 580+
This loan is exclusively for veterans, reservists, and active-duty personnel. You can finance 100% of the construction costs if you qualify. As with the FHA construction loan, the entire loan amount will convert to a regular VA mortgage after building is complete.
There are no maximum income or purchase price limits on this loan. However, you can only use it to buy a single-family home or a duplex. Also, similar to FHA loans, there are maximum loan limits. The baseline limit in 2022 was $1,100,700 for a four-unit home.
Conventional Construction Loan
- Minimum Down Payment: 20%
- Credit Score Requirement: 680+
A conventional construction loan is a private sector loan not backed by the government. As a result, the credit score requirements are higher, and the down payment is larger. However, there are no limits to the amount you can borrow.
This loan is a good choice if you don't qualify for a government-backed loan and have a large down payment. The main downside is that the down payment is larger, and the credit score requirements are higher.
Fannie Mae HomeStyle
- Minimum Down Payment: 3%
- Credit Score Requirement: 620+
This is an excellent choice if you want to buy and renovate a home. You can finance up to 97% of the purchase price and use special renovation mortgages to cover repairs and renovations.
This program is available in low-income areas and for folks who don't have a large down payment saved up. The main downside is that it's only available for one-unit homes.
- Minimum Down Payment: 3.5%
- Credit Score Requirement: 620+
The FHA 203(k) is similar to the Fannie Mae HomeReady program. It's available for folks who want to buy and renovate a home. You can finance up to 96.5% of the purchase price and use special renovation mortgages to cover repairs and renovations.
The main downside is that it's only available for one-unit homes. However, you can finance up to six months of mortgage payments into the loan, so you don't have to make any payments during construction.
Home Equity Loans
If you have equity in your home, you can use a home equity loan to finance the construction of your new home. The main benefit is that you don't have to make a down payment. However, you will need to have equity in your home to qualify.
The downside is that you are putting your home at risk if you can't make the payments. Home equity loans also have shorter repayment terms, meaning you will need to sell your home or refinance the loan when it's time to pay it back. There are three main types of home equity loans.
- Cash-Out Refinance: With this type of loan, you refinance your existing mortgage and take out a new loan for the difference. For example, if you have a $250,000 mortgage and want to borrow $50,000 for construction, you would refinance your mortgage for $300,000.
- HELOC: A HELOC is a home equity line of credit. You can borrow money as you need it up to your credit limit. This is a good choice if you don't know how much money you will need for construction or if you only need a small amount.
- Second Mortgage: A second mortgage is a loan in addition to your first mortgage. This is a good choice if you have much equity in your home and you need to borrow a large amount of money.