Understanding USDA Construction Loans
Erin Gobler6-minute read
December 14, 2021
*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 often make it difficult to achieve. A USDA construction loan is a way for home 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?
A USDA construction loan is a mortgage that is guaranteed by the U.S. Department of Agriculture (USDA). The program is designed to make housing accessible and affordable in rural areas. Like 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 the no down payment requirement. However, buyers may struggle to find a lender to service this type of loan.
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USDA Construction Loan Requirements
Government-backed loans such as USDA and FHA loans often have more eligibility requirements than conventional mortgages. The USDA construction loan is no exception. There's a long list of requirements borrowers must meet to qualify for this type of loan. Here are the USDA construction loan requirements:
- The property must be in a USDA-approved area.
- The property must be the primary residence.
- You must use a USDA-approved contractor.
- You must have a new construction warranty from the builder.
- You need a minimum credit score of 640.
- Your debt-to-income (DTI) ratio must be no more than 41%.
- Your total income cannot exceed the state's USDA income limit.
- You must not have experienced bankruptcy for at least 2 years.
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, though, 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 the building 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 do they cover single-family homes, but they may also cover 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 loans help to make rural housing more affordable and accessible. But there are several benefits and drawbacks to USDA construction loans, and it's important to weigh these factors when deciding whether to apply for this type of loan.
The Pros Of A USDA Construction Loan
USDA construction loans come with a variety of benefits. First, while typical USDA loans allow borrowers to purchase an existing home, a USDA construction loan can let borrowers to start from scratch, allowing them to get exactly what they need in a home.
Another benefit of a USDA construction loan is that, unlike traditional construction loans, they take out just one loan for the land, construction and finished home. This saves the borrower money because they only pay closing costs once. Borrowers also aren't required to make payments during the building process, allowing them to save money.
Finally, the single close loan ensures that borrowers only have to qualify for one loan and that an unexpected change in their finances doesn't hurt their prospects of closing on the second loan. 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 loan. Because they've already closed, they don't have to worry about it.
The Cons Of A USDA Construction Loan
USDA construction loans can be an excellent opportunity, but it's also important to understand the downsides. First, these loans may cost more in the long run than other types of mortgages. While there's no down payment requirement, borrowers will pay private mortgage insurance (PMI).
USDA construction loans also often carry a higher interest rate than other loan products. Luckily, borrowers may be able to lower that interest rate over time, such as with a USDA streamline refinance.
Another downside of this type of loan is that borrowers may have a difficult time finding a USDA construction loan lender. While the loans are backed by the USDA, they're underwritten by a traditional financial institution. However, not all lenders offer this type of loan.
What Are Alternative Options To USDA Construction Loans?
USDA construction loans are an excellent way for rural buyers to find their dream homes. But there are several other loan options for building a house, which may be easier to find than USDA construction loans. Buyers should consider how these options fit their budget and needs.
Rather than taking advantage of the USDA single close construction loan, buyers could use a land loan or construction loan 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 construction loan, 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 who meets the VA's loan requirements. Like the USDA loans, a VA loan doesn't require a down payment, and it has the extra benefit of not requiring PMI.
FHA One-Time Close Construction Loan
An FHA one-time construction loan is a type of home loan that's backed by the Federal Housing Administration (FHA). FHA loans are designed to help moderate-income borrowers with below-average credit scores buy homes.
There are some similarities between FHA and USDA loans – both allow for a single close and a construction-to-permanent loan. Unlike USDA and VA loans, though, FHA loans can require a 3.5% down payment (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 better credit and a more favorable DTI ratio to qualify for a conventional loan. They can also require a down payment of at least 3.5%.
Conventional construction loans also come with benefits. Often there are fewer requirements, meaning buyers have more flexibility when choosing or building a home.
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. Contractor requirements include:
- 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 just use any lender – it must be a lender that's a part of the USDA loan program and who offers USDA construction loans. To get preapproved, you'll need to provide information such as your income and employment verification, a list of your assets and liabilities, your DTI ratio and a credit check.
3. Send In Your Application
Once you've compiled all of the necessary information, you can send in your application. Make sure you 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.
The Bottom Line
The USDA loan program makes rural homeownership more affordable and accessible. When you use a USDA construction loan, you have the opportunity to build your dream home with attainable loan requirements. USDA construction loans are just one of many options, 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.
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