Understanding USDA Construction Loans
February 15, 2024 8-minute read
Author: Victoria Araj
*As of July 6, 2020, Rocket Mortgage® is no longer accepting USDA loan applications.
Homeownership is the ultimate dream for many Americans, but traditional loan requirements can make this dream difficult to achieve for some people. A USDA construction loan – sometimes known as a USDA building loan – is a way for buyers to build their dream home with a mortgage backed by the U.S. Department of Agriculture. These loans come with plenty of benefits, but it’s essential to understand all requirements before you get started.
What Is A USDA Construction Loan?
The USDA mortgage program is designed to make housing accessible and affordable in rural areas. As with a traditional USDA loan, home buyers borrow from a traditional lender, and the USDA backs the loan. The difference between the two is that while a typical USDA loan allows a borrower to buy an existing home, a USDA construction loan allows borrowers to finance a home build.
The USDA has simplified the financing process through its Single-Family Housing Guaranteed Loan Program, which allows for construction-to-permanent loans. Rather than needing separate loans for the construction and the home itself, buyers can utilize a single close loan.
These loans come with plenty of perks, such as a no down payment requirement. However, buyers may struggle to find a lender that offers this type of loan.
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USDA Construction Loan Requirements
Government-backed loans such as USDA and Federal Housing Administration (FHA) loans sometimes have more eligibility requirements than conventional mortgages. The USDA construction loan would fall into that category.
Borrower Requirements For A USDA Construction Loan
Here are the USDA construction loan requirements for borrowers:
- You usually need a minimum credit score of 640.
- Your debt-to-income ratio (DTI) typically should be no more than 41%. As part of this, the amount you spend on housing each month shouldn’t represent more than 29% of your pretax monthly income. Your lender may waive these DTI limits if you have certain compensating factors.
- Your total income can’t exceed the state’s USDA income limits.
- If you’ve experienced bankruptcy, you may have to wait 1 – 3 years to apply for a loan, depending on the type of bankruptcy and lender policies, among other factors.
Property Requirements For A USDA Construction Loan
As a non-conforming loan, a house built with a USDA construction loan isn’t subject to the traditional home purchasing standards of government-sponsored enterprises like Fannie Mae and Freddie Mac. However, homes built with a USDA construction loan do have the following requirements:
How Do USDA Construction Loans Work?
Most often, construction loans require that borrowers take out two separate loans. First, they may borrow a construction loan to finance the build. Once the construction is complete, they would close on their mortgage.
The USDA construction loan simplifies that process through a construction-to-permanent loan, also known as a single close loan.
The process combines a construction loan and a traditional USDA mortgage into a single loan. Borrowers have just one mortgage closing before construction begins. As a result, they also have just one promissory note and one set of closing costs. Once construction is complete, you’re left with a 30-year fixed-rate USDA loan.
What Do USDA Construction Loans Cover?
USDA construction loans offer up to 100% financing, meaning they cover everything associated with the home build, and buyers aren’t required to come up with a down payment. Not only can they be used for single-family homes, but they may also be used to build some condos and manufactured homes.
The construction loan covers expenses such as:
- Buying the plot of land
- Inspection fees
- Builder’s insurance
- Construction administrative fees
- Design plans
- Landscaping costs
- Building costs
- Utility and septic costs
The Pros And Cons Of USDA Construction Loans
USDA construction loans help make rural housing more affordable and accessible but come with several benefits and drawbacks. It’s important to weigh these factors when deciding whether to apply for this type of financing.
The Pros Of A USDA Construction Loan
USDA construction loans carry a variety of benefits that make them a popular option for borrowers who qualify. Next, we’ll look at a few of the benefits you can expect.
They Allow You To Build Your Dream Home
While typical USDA loans allow borrowers to purchase an existing home, a USDA construction loan can let borrowers start from scratch, allowing them to get exactly what they need in a home. You’re in control of the features, size and location of your home and can truly make it the home of your dreams.
They Streamline The Financing Experience
Unlike with traditional construction loans, borrowers using a USDA construction loan take out just one loan for the land, construction and finished home. This saves the borrower money because they only pay closing costs on a single loan. Borrowers also aren’t required to make payments during the building process, freeing up cash each month to help them cover rent and other living expenses until they can move into their new home.
They Give Borrowers Peace Of Mind
The single close loan ensures that borrowers only have to qualify for one loan and that an unexpected change in finances won’t hurt their prospects of closing on their mortgage. Imagine that, after closing on the construction loan, a change to the borrower’s credit score meant they would no longer qualify for their 30-year mortgage. Because they’ve already closed on a USDA construction loan, they don’t have to worry about losing out.
The Cons Of A USDA Construction Loan
USDA construction loans can be an excellent opportunity, but it’s also important to understand the downsides, which we’ll examine below.
They Come With Higher Costs
These loans may cost more in the long run than other types of mortgages. While no down payment is required, borrowers will pay upfront and monthly guarantee fees. The upfront fee will cost borrowers 1% of the loan amount, and the annual fee (broken down into monthly payments) will cost 0.35% of the remaining loan amount. That can add thousands of dollars to your total closing costs and hundreds of dollars to your monthly mortgage payment.
They Have Higher Interest Rates
USDA construction loans also often carry a higher interest rate than other loan products. The higher rates mean you may end up with a higher mortgage payment than you’d have if you financed the build with a different type of construction loan. Luckily, borrowers may be able to lower that interest rate over time with a USDA Streamline Refinance.
They’re Not Issued By All Lenders
Another downside of this type of loan is that some borrowers may have a difficult time finding a USDA construction loan lender. While the loans are backed by the USDA, they’re underwritten by traditional financial institutions. However, not all lenders offer this type of loan. The best action you can take is to speak with your lender about your options.
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How To Get A USDA Construction Loan
Here are the steps you’ll have to follow to apply for a USDA construction loan.
1. Find A USDA-Approved Contractor
Buyers must have an agreement with a USDA-approved contractor before they can qualify for a loan. The contractor must satisfy the following requirements:
- The contractor must have a minimum of 2 years of experience building single-family homes.
- The contractor must pass a background check.
- The contractor needs a minimum of $500,000 in commercial liability insurance.
- The contractor must have a satisfactory credit history.
- The contractor must have a construction or contractor license.
2. Find A USDA Construction Loan Lender
Once you have your contractor agreement in place, you can start working with lenders to get preapproved for your loan. Keep in mind that you can’t use just any lender – the lender must be part of the USDA loan program and offer USDA construction loans. To get your initial mortgage approval, you’ll need to provide information such as your income and employment verification, a list of your assets and liabilities, your DTI and a credit check.
3. Submit Your Application
Once you’ve gathered all of the necessary information, you can send in your application. Be sure to verify your contractor and property location before submitting your application since both are necessary to qualify. Depending on your situation, it could take anywhere from 30 – 60 days to complete the loan process.
What Are Alternative Options To USDA Construction Loans?
USDA construction loans are an excellent way for rural buyers to find their dream home. But several other loan options for building a house may be easier to find than a USDA construction loan. Buyers should consider how these options fit their budget and needs.
Rocket Mortgage® doesn’t offer construction loans at this time.
Rather than taking advantage of the USDA single close construction loan, buyers could use a land loan or construction loan to cover the cost of the build upfront and then combine that with a traditional USDA loan. Because these loans are still backed by the USDA, they come with many of the same requirements.
VA One-Time Close Construction Loan
Like the USDA, the U.S. Department of Veterans Affairs (VA) also guarantees home loans. You may be eligible for a VA construction loan if you’re a current or former military service member or a surviving spouse who meets the VA’s loan requirements. Like a USDA loan, a VA loan doesn’t require a down payment, and it has the extra benefit of not requiring PMI, but you’ll typically incur a funding fee.
FHA One-Time Close Construction Loan
An FHA one-time construction loan is a type of home loan backed by the FHA. FHA loans are designed to make homes affordable for moderate-income borrowers with a below-average credit score.
FHA and USDA loans both allow for a single close and a construction-to-permanent loan but unlike USDA and VA loans, FHA loans require a down payment of 3.5% (or 10% for those with credit below 580).
Conventional One-Time Close Construction Loan
Borrowers who don’t qualify for a government loan might consider a conventional one-time close construction loan. Conventional loans and USDA loans come with different sets of requirements, and you generally need a more favorable DTI to qualify for a conventional loan. One-time close construction loans not insured by the government typically require a down payment of 3% – 5% for a primary residence.
That said, conventional construction loans also come with benefits and often have fewer overall requirements than government-backed loans, meaning buyers have more flexibility when choosing or building a home.
FAQs About USDA Construction Loans
Here are a few frequently asked questions about USDA construction loans so you can decide if financing your new home build with a USDA loan is the right option.
What will a USDA construction loan cover in my build?
A USDA construction loan will let you finance the purchase of land for your homesite as well as the cost of the construction itself, including permits and any necessary fees.
Will I have to apply for a separate mortgage?
No. USDA construction loans convert into a 30-year mortgage once construction is completed. That means you won’t have to apply for an additional loan or pay closing costs on a separate mortgage.
Do I have to use a USDA construction loan to build a home in a rural area?
You aren’t required to use a USDA construction loan to build a home in a qualified rural area. Instead, you can use the financing method that best fits your needs and your budget.
The Bottom Line
The USDA loan program makes rural homeownership more affordable and accessible. When using a USDA construction loan, you have the opportunity to build your dream home while facing more flexible loan requirements for lender approval. USDA construction loans are just one of many options, though, so make sure to research the alternatives and find the loan that best fits your financial situation.
While Rocket Mortgage doesn’t offer USDA construction loans, we can help you identify which type of mortgage is best for you. If you’re looking to get a mortgage on a home that’s already built, you can start the mortgage process online or give us a call at (833) 326-6018.
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