What Is an FHA 203(k) Loan?
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A 203(k) loan is a type of FHA construction loan which you can use to finance not only the purchase of a home but also the funds required to renovate it. FHA 203(k) loans are the perfect solution for people interested in purchasing a fixer-upper, which many lenders may not approve of.
What You Should Know
- An FHA 203(k) loan can be used to finance the purchase of a house and the costs required to renovate it
- There are two types of FHA 203(k) loans: Standard 203(k) for major renovations and Streamline 203(k) for work that requires fewer improvements
- The renovations need to start within the first 30 days of closing on an FHA 203(k) loan and the work must be completed within 6 months since closing
- With an FHA 203(k) loan, the funds to renovate are kept in an escrow account and distributed as each stage of the renovation is completed
- FHA 203(k) loans cannot be used for investment properties or cooperative units
What is an FHA 203(k) Loan?
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With an FHA 203(k), borrowers can use the funds borrowed to finance the purchase of a house and the renovation or improvements that it might need. Since it is an FHA-insured mortgage, the FHA 203(k) loan is targeted towards low and medium-income families who may not be able to afford a home otherwise. This is due to the more lenient requirements of an FHA 203(k) loan compared to traditional loans.
The FHA 203(k) loans also address the problem of fixer-uppers. Lenders do not always approve of a house that needs many renovations. However, with an FHA 203(k) loan, the lender can directly track the progress made on the house. Moreover, funds for renovation are not released all at once. Instead, the funds are put in an escrow account and the payments to constructors are made according to the completed work.
How Does a 203(k) Loan Work?
FHA 203(k) loans come in two terms, 15 years or 30 years, and you can take out a fixed-rate 203(k) loan or an adjustable-rate one from any HUD-approved lender. When you apply for the loan, the amount asked for must reflect the future value of the property once the improvements are made and the cost of improvements themselves.
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The FHA requires its borrowers to use a minimum of $5,000 on home improvements. This amount is meant to be used towards eliminating building code violations or making safety improvements to the property. The rest of the funds is then put in an interest-bearing account and it is distributed as stages of the renovation process are completed. You are not allowed to make major cosmetic changes to your property such as adding a new swimming pool or tennis court. Another requirement of FHA 203(k) loans is that the work done must be completed within 6 months of the loan’s closing date.
It is important to note that a licensed handyman must be handling the construction in the house. While you are allowed to do the work yourself if you are a licensed handyman, you cannot compensate yourself using the 203(k) loan funding. Instead, you can use the rest of the funds to cover any unexpected costs you may incur or you can make additional repairs to the property.
FHA 203(k) Loan Requirements
The requirements to qualify for an FHA 203(k) loan are quite similar to the requirements of a regular FHA loan. This means that they are easier to qualify for than a traditional conventional mortgage. Some of these requirements include:
Credit Score - You must have a credit score of at least 500 in order to qualify for an FHA 203(k) loan. However, some lenders may require a higher minimum credit score.
Minimum Down Payment - You would have to make a minimum down payment of only 3.5% if your credit score is at least 580. On the other hand, if your credit score is less than 580 but higher than 500, you would be required to make at least a 10% down payment.
Maximum Debt-to-Income Ratio - Your debt-to-income ratio shows what portion of your income makes up your monthly debt obligations. This will include your monthly mortgage payment, any car loan payments you might have, student loan payments, credit card bills, etc. In order to qualify for an FHA 203(k) loan, this DTI ratio must be at most 45%. Depending on the lender, some may require a lower one, and others may be more lenient and allow a higher DTI ratio.
Maximum Loan Amount - With an FHA 203(k) loan you can either borrow 110% of the expected future value of your home, or the purchase price of the home plus renovation loans. The lender will approve of whichever amount is smaller. It is important to note that this amount can not exceed the FHA loan limits for your region.
Occupancy - In order to qualify for an FHA 203(k) loan, the house you are borrowing for must serve as your future primary residence. You can not use an FHA 203(k) loan to borrow for an investment property.
Types of FHA 203(k) loans
There are two types of FHA 203(k) loans that differ from one another mainly by the condition of the house and the improvements that it needs:
Standard 203(k) loan
A standard 203(k) loan is typically used when major renovations need to be made on the house. This type of loan does not have a cap amount of funds you can borrow that you cannot exceed, as long as you don’t pass the whole maximum FHA loan amount for your region. Some of the repairs you can use a standard 203(k) loan for include:
- Major structural repairs
- Major landscape and site improvements
- Additional construction such as additional rooms
- Elimination of safety hazards
- Major improvements that need architectural designs
- Expanding or building a garage or carport
- Completing a basement or attic conversion or adding a second story
- Adding a porch, deck, or patio
Streamline 203(k) Loan
The streamline 203(k) loan is meant to be used when the home does not need as many repairs. There is a cap of funds up to $35,000 with the streamline 203(k) loan. Typically, big construction projects cannot be undertaken using this type of loan. Some of the renovations you can fund with this limited version include:
- Waterproofing the basement
- Repairing or replacing the roofs
- Repairing or replacing the HVAC systems
- Updating the house’s appliances
- Updating the home’s electrical system
- Painting the house
- Repairing the exterior of the home
- Replacing or repairing the plumbing system
- Remodeling bathrooms or a kitchen, including new built-in appliances
- Installing energy-efficient windows or doors
How to get an FHA 203(k) Loan?
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The process of purchasing a house using an FHA 203(k) loan is similar to buying a home with a traditional mortgage. Most of the differences between the two processes take place after you have purchased the home and are ready to do the renovations. The steps to get an FHA 203(k) loan can be summarized as below:
Find a lender - You will need to look for an FHA-approved lender that offers 203(k) loans. Just as with any other mortgage, you will need to shop around in order to get the best terms for your loan.
Apply for the 203(k) loan - To make the process as fast and seamless as possible, make sure you gather all the documentation needed for the loan beforehand. Your mortgage pre-approval will help you when negotiating on a home.
Search for an eligible property - HUD has a list of the types of properties that they permit to be financed through the FHA 203(k) loans. Investment properties and cooperative units are not part of this list.
Talk to an FHA 203(k) consultant - You will need to speak to a HUD consultant regarding the scope of your work. This person will also be responsible to overlook the work is done correctly and in a timely manner.
Find a contractor - You will need the help of a licensed professional in order to estimate the work that needs to be done in the home, how much the projects will cost and whether they can be completed in a 6-month period.
Home Appraisal - To estimate the maximum amount they can lend you, the lender will appraise the value of the property with and without the improvements.
Close on your loan - Once you have signed the papers on your FHA 203(k) loan, you can officially start working on your new house.
What Types of Properties are Eligible for an FHA 203k Loan?
The Department of Housing and Urban Development places restrictions on which type of properties borrowers can finance through an FHA 203(k) loan. There are 7 types of properties that HUD lists as eligible. These include:
A one-to four-unit residence that has been completed for at least one year, such as detached homes and townhouses
Condominiums in one-to four-unit buildings
Mixed-use residential properties that include commercial space
Conversion of a one-unit residence to a two-, three-, or four-family dwelling
Conversion of an existing multi-unit dwelling down to a one-to four-family unit
An existing house or modular unit on another site that can be moved onto the mortgaged property
Homes that have been demolished or will be razed as part of rehabilitation work if some of the existing foundations remain in place
Investment properties and cooperative units cannot be financed through 203(k) loans.
Documentation Required for FHA 203(k) Loans
An FHA 203(k) loan requires a number of additional documents for each stage of the application on top of the ones needed for a typical FHA loan. Some of these documents include:
| Stage | Form |
|---|---|
| Application Stage | Purchase Contract - It must be outlined in the contract that the borrower has applied for an FHA 203(k) loan |
| Rehabilitation Agreement - This form needs to acknowledge the fact that the borrower has the ability, experience, and tools to complete the improvements | |
| Homeowner/Contractor Agreement - There needs to be a legal agreement between the homeowner and the contractor, which outlines the work to be performed, the costs, and the time period | |
| Feasibility Study - It needs to be shown that the project is financially feasible | |
| Processing Stage | 203(k) Borrower’s Acknowledgement - Gives a description of the program and the borrower’s responsibilities |
| Borrower’s Certification - Identity of Interest - The borrower must certify that they do not have an Identity-of-Interest or Conflict-of-Interest with other parties involved in the transaction | |
| Consultant Borrower Agreement - The written agreement between the borrower and consultant. This document must include an explanation of the work to be performed and the fees for the services provided | |
| Contractor Bids - This will assist in repair cost establishment |
Other documents must be provided by the consultant. Some of these documents include:
- Consultant’s Certification - Identity of Interest
- Work Write-Up
- Cost Estimate
- Draw Schedule
- Rehabilitation Loan Agreement
Pros and Cons to FHA 203(k) Loans
Before deciding to take out a 203(k) loan, make sure you know what you are getting into by exploring the benefits and drawbacks an FHA 203(k) loan presents:
| Pros | Cons |
|---|---|
|
|
Pros
Low down payment - While other loans require borrowers to make a 20% down payment, with an FHA 203(k), you can make a payment as low as 3.5% if your credit score is at least 580, or 10% if your credit score is lower than 580.
Take out only one loan - FHA 203(k) loan provides borrowers with the opportunity to take out only one mortgage, which they can use to finance the purchase of the house and costs of improvements.
Gain instant equity - Some homes that need renovations are sold at prices much lower than they would have if the renovations were undertaken. Therefore, the value of these homes significantly increases when they’ve been renovated. This means that once you conduct the work on your home with an FHA 203(k) loan, you can instantly have some equity in it.
Lower Interest - While the mortgage rates on FHA 203(k) loans are slightly higher than mortgage rates for standard FHA loans, they still are lower than what most credit cards or personal loans offer.
Save on taxes - Contrary to using credit cards to finance your home improvements, using an FHA 203(k) loan lets you deduct the interest you pay on your mortgage when you file your income taxes.
Cons
You’re on a time crunch - HUD requires all FHA 203(k) borrowers to finish their renovations in a time period of 6 months. This means that you will have to make sure that all contractors are on track with the timeline of the project.
You will need professional help - In order for the project to go smoothly and for the work to be completed on time, you will need to hire reputable contractors to conduct the work.
Lots of decisions - You will need to be prepared for what renovations and changes you would like in your new home. You are required to start the work within the first 30 days of closing on the loan. Therefore, it would be smart to think beforehand about the changes you would like to make.
More paperwork - Compared to a traditional mortgage, an FHA 203(k) loan requires you to submit and sign more paperwork than usual. The reason for this is that the FHA will need to assess your credibility as a buyer, the condition of the home you are interested in, and the plan to renovate it.
FHA 203(k) vs. Construction Loans
One of the main differences between FHA 203(k) loans and construction loans is that construction loans are typically taken out when the borrower wants to build a house from the ground up and not simply perform renovations on a fixer-upper. A traditional construction loan is not government-backed, which means that the qualification criteria are not as lenient as in FHA loans. Moreover, the funds with a construction loan can be taken either in installments or as a lump sum. At the end of the house’s construction, a borrower can either pay the whole amount in full or refinance the mortgage into another one. Interest rates tend to be higher on construction loans.
Government departments such as HUD, VA, and USDA also offer construction-to-permanent loans. These options have the common advantages of low to no down payment at all, low credit score requirements, and low interest rates.
FHA 203(k) vs. FHA 203(b)
An FHA 203(b) loan is similar to an FHA 203(k) loan in many aspects. Starting from the eligibility requirements, to using the loans to finance repairs in a home, the two types of FHA loans are pretty much the same. However, the main difference is that with an FHA 203(b) loan you can only make repairs up to $5,000.
When you apply for an FHA 203(b) loan, the home appraisal must show that the property would not need more than $5,000 in repairs. Therefore, if you believe that the property you’re interested in would require up to $10,000 worth of improvements, then an FHA 203(k) loan may be a more suitable option. Lastly, a 203(k) loan tends to have an interest rate 1% higher on average than 203(b) loans.
Other Alternatives to FHA 203(k) Loans
If you believe that the FHA 203(k) loan is not the right one for you. There are other home improvement loan options that you can explore if you are looking to renovate your home. The catch is that with most of these options, you would need to have purchased the home first and have built some equity in it.
HELOC - A home equity line of credit resembles a credit card where your spending limit is decided beforehand. This means that you can borrow funds according to how much you exactly need and when you need them. A HELOC allows you to borrow money against your home equity and then use the funds to make the home improvements. These types of loans have variable interest rates and unfortunately, you must have at least 20% of home equity in order to be eligible.
Home Equity Loan - A home equity loan is similar to a HELOC where you borrow against your home’s equity. However, the difference is that with a home equity loan you can only borrow one amount all at once at the beginning of the loan. Just like a HELOC, in order to be eligible, you must have 20% equity in your home.
Cash-out Refinance - With a cash-out refinance, you can borrow a bigger loan in order to pay off your existing one and use the leftover cash for home improvement projects. This means that you can choose a mortgage with more favorable terms such as a lower interest rate than what you are currently paying. It is worth mentioning there are refinance fees with this option.
HomeStyle Loan - This is a program offered by Fannie Mae, where you can repair or remodel a house by putting as low as 3% down if the mortgage rate is fixed, or 5% if the rate is adjustable. This option offers lower mortgage rates than the other options of HELOCs, home equity loans, or personal loans. In contrast to FHA 203(k) loans, HomeStyle loans can also be used for luxury improvements.