What is a USDA construction loan?

What is a USDA construction loan?

A USDA construction loan is backed by the U.S. Department of Agriculture, as part of a program designed to make rural homes more affordable. USDA construction loans combine the purchase of land — usually five acres or more — with the cost of constructing a house on that land in a designated area.

As with a traditional USDA loan or other government-backed mortgages, homebuyers borrow from a traditional lender and the USDA backs the loan.

With the USDA construction loan, you have the convenience and reduced expense of a single-close loan that combines the land and the home’s construction cost.

These loans come with plenty of perks, such as a no down payment requirement. However, Bickerstaff warned that it can be challenging for homebuyers to find a lender with expertise in USDA loans. He suggests consulting a realtor or mortgage broker for recommendations.

» COMPARE: Best USDA lenders

How do USDA construction loans work?

As with any mortgage loan, you’ll be asked to submit an application that includes information about your past and current financial situation.

In addition, a USDA loan will require information about the property you plan to purchase to confirm it is in a USDA-designated rural area. Your builder will also have to meet USDA requirements in order for the loan to be approved.

Once you’ve secured a USDA construction loan, the loan itself works just like a traditional 30-year fixed-rate mortgage with regular monthly payments over the term of the loan.

Pros and cons of USDA construction loans

USDA construction loans can be a great option if you’re planning to build in a rural area, but they won’t suit everyone. Consider the pros and cons as you’re comparing borrowing options.

How to get a USDA construction loan

The application process for a USDA construction loan isn’t much different from a traditional  mortgage. Your application will be completed and submitted through a traditional bank.

However, because the loan is backed by the USDA, there are specific requirements for the homebuyer, the homebuilder and the property itself.

For the homebuyer

Your total household income cannot exceed the USDA income limits for your local area. These generally start at $110,650 for a household of up to four, but they may be higher based on an area's cost of living.

There is no prescribed minimum credit score requirement for USDA loans, but some lenders may set a minimum of 640.

In addition, you’re likely to need a debt-to-income ratio at or below 41%. The amount you spend on housing, including property taxes, insurance and homeowners association fees, can't be more than 29% of your income.

For the property

USDA construction loans are aimed at helping homebuyers in rural areas, so you may find that they include more property restrictions than conventional loans.

Your home will have to fall within one of the USDA's designated rural areas, and it must be your primary residence. Rental or vacation properties won’t qualify.

The USDA also stipulates that your new home must fit the area in order to qualify. This typically means the home cannot exceed 2,000 square feet, but certain exceptions may apply. You’ll want to discuss your plans with your lender as early as possible.

For the builder

A USDA new construction loan also has specific requirements for the contractors involved in the project.

Any builders must be approved by your lender, have at least two years of experience with single-family home construction and be fully licensed for the work. They must also have a strong credit history, clean background check and minimum of $500,000 in liability insurance.

Alternatives to USDA construction loans

If you have trouble finding a lender to handle a USDA construction loan — or if any part of your plan doesn’t meet USDA requirements — there are alternatives.

Many banks offer traditional construction-to-permanent mortgages that offer the same one-time close you’d have with a USDA loan.

In addition, there are other government-backed mortgages that offer no down payment, such as VA loans (for veterans, active-duty service members and surviving spouses of the U.S. military) and FHA loans (for homebuyers who may not meet the requirements for a conventional mortgage).

Both of these options have their own qualifying criteria, so talk to your banker or realtor about whether you qualify.

» MORE: Construction loans: What they are and how they work

Bottom line

While it may take some time to identify a lender and locate a qualified contractor, you will save cash if you qualify for a USDA construction loan. Plus, USDA financing can be used to cover nearly every foreseeable expense in building your home, so you can keep more cash on hand to cover additional expenses such as moving costs and utility connections.

“Your lender may not suggest a USDA construction loan as a first option for rural new construction,” said Bickerstaff. “USDA loans constitute less than 10% of transactions in a given area, but it’s definitely worth the extra effort to have your banker or realtor see if your property and home plans will qualify.”