Understanding USDA construction loans

*As of July 6, 2020, Rocket Mortgage^® is no longer accepting USDA loan applications.

A USDA construction loan – sometimes known as a USDA building loan – is a way for buyers to build their dream homes with a mortgage backed by the U.S. Department of Agriculture (USDA).

Homeownership is the ultimate dream for many Americans, but traditional loan requirements can make this dream difficult to achieve for some people. The USDA does offer construction loans that come with plenty of benefits, but it’s essential to understand all requirements before you get started.

What is a USDA construction loan?

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 mortgage program is designed to make housing accessible and affordable in rural areas. As with a traditional USDA loan, home buyers can borrow from a traditional lender, and the USDA backs the loan.

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, including no down payment requirement. However, buyers may struggle to find a lender that offers this type of loan.

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 falls into that category.

Borrower requirements for a USDA construction loan

Here are the USDA construction loan requirements for borrowers:

• Your lender may require 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 the wait could be longer or shorter depending on your situation. Check with your lender for details.

Property requirements for a USDA construction loan

As a nonconforming 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:

• 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.

How do USDA construction loans work?

Most often, construction loans require that borrowers take out two separate loans. First, they may take out 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 in my build?

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. 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.

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
• Permits
• 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 before applying 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.

Allows 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. This allows you 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 build the home of your dreams.

Streamlines 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. This frees up cash to cover rent and other living expenses until they can move into their new home.

Gives borrowers peace of mind

The single close loan ensures that borrowers only have to qualify for one loan. That means that unexpected changes in finances won’t hurt your chances of closing on your mortgage. After closing on the construction loan, a negative change to your credit score could mean you no longer qualify for a 30-year mortgage. Since you’ve already closed on a USDA construction loan, you won’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.

Comes 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 USDA 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.

Often has 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 if you financed your construction with a different type of construction loan. Luckily, borrowers may be able to lower that interest rate over time with a USDA Streamline Refinance.

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.

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 your 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 submit your application. Be sure to verify your contractor and property location before submitting 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.

USDA loan

Instead of a USDA single close construction loan, buyers could use a land loan or construction loan to cover the cost of the build upfront. Then you could combine that with a traditional USDA loan for final mortgage financing. 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. Additionally, VA loans don’t require private mortgage insurance (PMI). Instead 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. Unlike USDA and VA loans, FHA loans require a down payment of 3.5% (or 10% for those with a credit score 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. They often have fewer overall requirements than government-backed loans, meaning buyers have more flexibility when choosing or building a home.

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, 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 in the market to buy an existing home, you can begin the mortgage approval process online or give us a call at (833) 326-6018.