FHA 203(k) Loans: What They Are And How They Work

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When you buy a home, there are usually a few repairs to pay for. Buyers who want to take on a real fixer-upper might be facing the prospect of many projects.

If this is the case for you, you may be considering an FHA 203(k) loan, also known as a FHA 203(k) rehab loan or Section 203(k) loan, which combines the financing for both the home’s purchase and remodeling or repairs into a single loan.

What is an FHA 203(k) loan?

An FHA 203(k) loan is a mortgage product insured by the Federal Housing Administration that allows homebuyers to borrow enough money to cover both the cost of the home and the price of necessary repairs, including labor and materials.

Certain 203(k) loans may allow you to finance up to six months of mortgage payments. Note that the FHA does not lend the funds for 203(k) rehab loans. Rather, it provides financial protection to lenders that do.

There are also two types of 203(k) rehab loans. The Limited 203(k) loan is designed for projects valued at less than $35,000, and because of that, it has an easier application process. In addition, there is no minimum cost requirement, but you can’t pay for structural repairs with this loan.

The Standard 203(k) loan targets more extensive jobs that cost more than $35,000, including major work such as structural changes, like additions, or full home renovations. There is a minimum loan amount with this loan of $5,000. This loan also requires that the homebuyer obtain architectural exhibits and meet building codes.

How does an FHA 203(k) loan work?

A 203(k) renovation loan can be a 15- or 30-year fixed-rate or adjustable-rate mortgage (ARM). The amount you can borrow depends on criteria such as your credit rating and income. The total amount borrowed through 203(k) loans must be within FHA loan limits for the area in which the home is located.

Generally, the most you can borrow for the loan is the lowest of the following:

• The FHA’s maximum loan limit for the county where the property is located
• A calculation involving the home’s “before” value plus improvement costs
• A calculation involving the home’s “after” value, including the improvements

If you opt for a 203(k) loan, you’ll typically work with a licensed contractor to handle renovations, and they should be familiar with this kind of loan, especially the payment schedule and requirements. Occasionally, a 203(k) loan borrower may do some or all of the work themselves. However, this requires approval from the lender.

Once the renovations are completed, you must provide a letter, and a HUD-approved consultant will evaluate the work. You can find a consultant through your lender or on the FHA website.

FHA 203(k) loan requirements

There are various requirements you must meet to qualify for an FHA renovation loan, including:

• Borrower must be the owner or occupant – The main restriction for an FHA 203(k) loan is that the borrower has to be the owner or occupant of the house. Investors are not eligible for this kind of loan, although in certain situations, nonprofit organizations may be allowed to obtain one.
• Obtained through an FHA-approved lender – You can only obtain a FHA 203(k) rehab loan through an FHA-approved lender. HUD’s lender list allows you to search for approved lenders offering FHA rehab loans in your area.
• Credit score – A minimum credit score of 500 or higher is required. Those with a credit score above 580 are eligible for maximum financing of 96.5 percent. Applicants with credit scores between 500 and 579 are limited to financing of a maximum 90 percent loan to value.
• Down payment – The minimum down payment is 3.5 percent.
• Debt-to-income ratio – The maximum debt-to-income (DTI) ratio is 43 percent.
• Renovation costs – The cost of renovations must exceed $5,000 for a standard 203(k) loan or be less than $35,000 for a limited 203(k) loan.
• Renovation completion time – FHA 203(k) loans require that the work must be completed within six months after closing, depending on the project’s scope

There are also minimum energy-efficiency and structural standards that the project must meet to qualify.

What can an FHA 203(k) loan be used for?

A standard 203(k) loan can cover many projects that increase your home’s value. This is a partial list:

• Structural alterations and reconstruction
• Modernization and improvements to the home’s function
• Elimination of health and safety hazards
• Changes that improve the appearance and eliminate obsolescence
• Reconditioning or replacing plumbing (for example, installing a well and/or septic system)
• Adding or replacing roofing, gutters and downspouts
• Adding or replacing floors and/or floor treatments
• Major landscape work and site improvements
• Enhancing accessibility for a person with disabilities
• Making energy conservation improvements

Work on certain properties, such as co-ops, cannot be financed with a 203(k) loan. Mixed-use properties with commercial and residential space may be eligible if the work is solely for residential use.

Some projects don’t qualify for 203(k) financing. If the change doesn’t result in a true upgrade, you can’t use a 203(k) loan to pay for it. Luxury add-ons like swimming pools, hot tubs, tennis courts and outdoor fireplaces aren’t covered.

FHA 203(k) loan pros and cons

FHA 203(k) loan refinancing

You can use FHA 203(k) loans to purchase a fixer-upper or rehabilitate the home you already live in through a refinance. The process to refinance into a 203(k) loan is similar to a regular refinance, but you must meet the additional requirements of the 203(k) loan.

After refinancing, a portion of the 203(k) proceeds will pay off your existing mortgage, and the rest of the money will be kept in escrow until repairs are completed. Existing 203(k) mortgages can also be refinanced through the FHA streamline program, which may help you get an even lower interest rate.

Other ways to finance a home renovation

FHA 203(k) loans are one of several options to pay for home improvements. Other options include:

• Cash-out refinance: In this scenario, you borrow more than you owe on your existing mortgage and apply the proceeds to renovations. Cash-out refinancing requires having equity in your home — usually at least 20 percent.
• Home equity lines of credit: HELOCs have one significant caveat: To borrow against your house, you must have plenty of home equity. Before considering a HELOC, make sure the value of your home is significantly higher than the amount you still owe on your mortgage. HELOCs usually close quickly and carry variable interest rates.
• Home equity loans: Essentially a second mortgage, a home equity loan comes with a fixed interest rate. As with a HELOC, you’ll need sufficient equity. Financial technology company RenoFi connects homeowners with credit unions willing to lend against the value of a home after improvements.
• Fannie Mae HomeStyle or Freddie Mac CHOICERenovation loans: The HomeStyle loan and CHOICERenovation options also allow you to borrow against the future value of your home.
• Personal loan: A personal loan is a fixed-rate product you can use to finance home improvements. These loans don’t require collateral, though you’ll generally need good credit to qualify.
• Selling a stake in your home: A new breed of financial technology firms is pitching American homeowners on a different way of tapping into home equity. If you’re sitting on a pile of it, these companies — including Haus, Hometap, Point and Unison — will buy a piece of your house. You repay the “co-investment” when you sell. One downside: This money comes at a higher cost than a mortgage or HELOC.

FHA 203(k) loan FAQ

• How is an FHA 203(k) loan different from a construction loan?

  While an FHA 203(k) is a type of construction loan that funds the purchase of a home and qualifying renovations, a construction loan is a short-term, higher-interest loan that funds building or updating a house in installments rather than a lump sum. Once construction is completed, the homeowner can convert the loan to a conventional mortgage.

  You can use a construction loan for anything structural, such as replacing a roof. Or you can use it to put in a swimming pool or build an outdoor kitchen. By contrast, neither of these items would qualify for a standard FHA 203(k) rehab loan.

• What types of properties are eligible for an FHA 203(k) loan?

  FHA 203(k) rehab loans are designed for the repair of single-family properties. You can also use the loans to convert a single-family home into a two-, three- or four-unit home. You can also use them to convert multi-unit homes into a single-family home. In addition, FHA 203(k) rehab funds can cover the costs of rehabilitating the residential portion of a property that also has non-residential uses. The program also requires that a one- to four-unit property be at least one year old and that you ultimately use the property as your primary residence.

• Can I do the renovations myself for an FHA 203(k) loan?

  In general, the work done using an FHA 203(k) rehab loan must involve a qualified, licensed and insured contractor. Unless you are a professional contractor, you can’t do the work on your own.

• Can I use the FHA 203(k) loan for purchasing a property in need of a complete rebuild?

  The FHA 203(k) loan allows you to use funds for everything from minor repair needs to nearly the entire reconstruction of a home, as long as the original foundation is kept intact.