Two men working on a home project
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It’s not uncommon to want to buy a fixer-upper to unlock its potential with renovations. However, for many people it’s a bridge too far to come up with the down payment and foot the repairs and upgrades that home might need. This is where getting an FHA loan can make a difference.

Remodeling your next home and getting a mortgage for the fixer-upper can be easily accomplished in the same transaction with a Federal Housing Administration home loan.

The FHA home loan program offers a mortgage which combines both goals, the FHA-insured Section 203(k) loan. If living in a home while it is undergoing a makeover sounds acceptable, then the FHA construction loan could be the right fit for you.

Pros and cons of FHA construction loans

Pros

  • Low minimum down payment requirement
  • Relatively low credit score requirements
  • Cover mortgage payments if the home can’t be lived in during renovations
  • Might get a lower interest rate than with personal loans or credit cards

Cons

  • Might need to get a HUD consultant
  • More extensive repairs require more paperwork
  • Might be additional costs associated with architectural assessments
  • FHA mortgage insurance is required

FHA construction loan benefits for homebuyers

Homebuyers hoping to find a good deal from short sales and foreclosures often focus on older properties that need to be remodeled or updated extensively. Obtaining one loan for the purchase and renovation can be cheaper than trying to get one loan for the purchase and then going back later for a home improvement loan. Additionally, using the FHA construction loan ensures that you have money for the repairs.

“This can be used when buying a home that is in need of major repairs before it can become inhabitable, and will save time and money because you get one loan that covers both the purchase price and the costs of the ongoing repairs,” says Greg McBride, CFA, chief financial analyst for Bankrate.

There is one catch – the total amount borrowed must still be within FHA loan limits for the area where the home is located, he says.

A 203(k) FHA loan is a good fit for older homes, but not ones that are fairly new and not in need of major fixes since a minimum of $5,000 must be spent for renovations.

“This can be beneficial for those who anticipate the need for making costly repairs but want to avoid taking on additional home equity loans,” says Bruce McClary, spokesperson for the National Foundation for Credit Counseling, a Washington, D.C.-based non-profit organization.

The 203(k) loan also offers solid refinance rates for cash-strapped homeowners who either can’t or don’t want to tap their home equity.

Limited vs. standard 203(k) FHA construction loan

The FHA offers two kinds of 203(k) loans.

  • A streamlined or limited 203(k) has an easier application process and the repairs or improvements must total $35,000 or less.
  • The standard 203(k) requires additional paperwork and applies to improvements costing more than $35,000.

Either type of 203(k) loan requires a minimum of $5,000 to be spent on rehabilitation of the home.

Generally, the maximum amount you can borrow for the mortgage is the lowest of the following:

  •    The FHA’s maximum mortgage limit for the area.
  •    A calculation involving the home’s “before” value plus improvement costs.
  •    A calculation involving the home’s “after” value, including the improvement.

You must apply for a Section 203(k) mortgage through an FHA-approved lender. It’s also important to understand that the FHA loan limits are based on area. While most FHA loans are limited to $331,760 in 2020, there are areas of the country where the limits are higher. Before getting an FHA construction loan, double-check the loan limits. Here’s the loan limits for every county in the U.S.

The rules on FHA 203(k) loans

While 203(k) loans can be used for refinancing as well as purchase loans, the main restriction is that the person seeking the mortgage has to be the owner or occupant. Investors are not eligible for this FHA loan.

Additionally, there are rules regarding the timeframe for completing the work. The work must begin within 30 days of closing and be completed within six months.

“This loan isn’t for everyone and there are some important restrictions,” McClary says. “Repairs will need to be completed in six months and the loan is not for investors. It’s a good idea to consider different types of financing if you are anticipating minor repairs since a 203(k) is better suited for major projects that are necessary to transform neglected properties into more habitable living spaces.”

Contractors should be familiar with the program, especially the payment schedule and requirements. Be sure to ask any contractor you hire if they are familiar with the program.

When the renovations are completed, the mortgage borrower is required to provide a letter and a HUD-approved cost consultant conducts an evaluation. Consultants can be found through a lender or via the FHA website.

FHA rules: A new roof, yes. New pool, no

The FHA program limits the projects to structural alterations and reconstruction and modernization and improvements to the home’s function. Some of the projects that qualify under an FHA construction loan include:

  • Plumbing and sewer system rehabilitation
  • Replace or install flooring
  • Repair or replace the roof and gutters
  • Make improvements to the landscaping
  • Upgrade the home so that it’s accessible to disabled persons
  • Get rid of safety and health hazards
  • Improve the energy-efficiency of the home

There are projects that do not qualify for 203(k) financing including luxury items such as a swimming pool or a hot tub. Basically, if the change doesn’t result in a true upgrade in terms of function or enhanced attractiveness to the home, you can’t use the 203(k) to pay for it.

How to qualify for a 203(k) loan

FHA loans were created to allow people to buy a home with a smaller down payment. The minimum amount for a down payment is 3.5 percent of the total loan amount that includes both the cost of the house and renovations.

A credit score of at least 580 is needed to be approved for the loan at the 3.5 percent down payment. However, it’s also possible to get an FHA loan with a credit score as low as 500 — but you’ll have to make a down payment of 10 percent. Even with these lower credit requirements, though, keep in mind that many lenders require a score of 620 or higher. Shop around and compare rates.

The loans require an upfront mortgage insurance payment of 1.75 percent of the total loan amount, which can be wrapped into the financing.

Borrowers also pay a monthly mortgage insurance premium based on the loan-to-value ratio and length of the mortgage.

What is a FHA cash-out refinance?

Another option, especially if you want to make changes that aren’t covered by the 203(k) loan, or if you don’t need to borrow at least $5,000 for repairs, is an FHA cash-out refinance.

With this loan, you can get a bigger FHA loan and use it to pay off your current mortgage. The difference in cash is paid out to you — and it can be used to remodel your home or make other upgrades.

To qualify for an FHA cash-out refinance, you must meet the following requirements:

  • Credit score of at least 500
  • Debt-to-income ratio of no more than 43 percent
  • Total loan-to-value ratio of no more than 80 percent
  • You must show that you’ve made all your mortgage payments for the last 12 months (or since you’ve had the home, if you’ve had it less than a year)
  • Pay mortgage insurance of 1.75 percent up front and 0.80 percent of the balance yearly

These requirements the requirements of an FHA loan vs conventional mortgage when getting a cash out refinance are a little easier to meet. For example, you might need a credit score of at least 620 — and likely it would need to be higher — to qualify for a conventional loan. You might also have a harder time meeting debt-to-income requirements.

It’s possible to find low FHA cash-out refinance rates by shopping around. Speak with an FHA lender about your eligibility, as well as to determine what the FHA cash-out refinance rates today are.

Bottom line

If you’re hoping to get affordable financing to remodel or upgrade your home, whether you’re a long-time homeowner or a first-time homebuyer, there are FHA construction loan and cash-out refinance options. Do some comparison shopping to determine what is likely to work for you — and to help you find the best FHA lender for your situation.

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