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 mortgage 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?
- How does an FHA 203(k) loan work?
- FHA 203(k) loan types
- FHA 203(k) loan pros and cons
- FHA 203(k) loan qualifications
- FHA 203(k) loan rules
- Cost of an FHA 203(k) loan
- How to find an FHA 203(k) loan lender
- FHA 203(k) loan refinancing
What is an FHA 203(k) loan?
An FHA 203(k) loan is a mortgage product backed 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 include funding for up to six months of mortgage payments. Note that the FHA does not lend the funds for a 203(k) loan. Rather, it provides financial protection to lenders that do.
How does an FHA 203(k) loan work?
A 203(k) loan can be a 15- or 30-year fixed-rate mortgage or an adjustable-rate mortgage (ARM).
The amount you can borrow depends on criteria such as credit rating and income. The down payment requirement is 3.5 percent of the purchase price plus repair costs, and the maximum loan amount is capped at 110 percent of the home’s appraised value. Additionally, lenders require the borrower to pay mortgage insurance. Rates on 203(k) loans may be higher compared to conventional loans, as well.
There is another catch, too: The total amount borrowed 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 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
In most cases, the renovations are done by a licensed contractor, but occasionally, a 203(k) loan borrower can do some or all of the work themselves. This requires approval from the lender.
A 203(k) loan is a good fit for older homes, but not ones that are fairly new and don’t need a minimum of $5,000 in renovations.
“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,” explains Bruce McClary, senior vice president of communications for the nonprofit National Foundation for Credit Counseling in Washington, D.C.
A 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.
FHA 203(k) loan types
The FHA insures two types of 203(k) loans:
- Limited 203(k): The limited 203(k) loan has an easier application process because it’s for projects valued at less than $35,000. There is no minimum cost requirement, but you can’t pay for structural repairs with this type of loan.
- Standard 203(k): The standard 203(k) loan is for extensive jobs costing more than $35,000. The minimum loan amount for this type is $5,000. Structural changes, like additions or full home renovations, are permitted. The homebuyer must obtain architectural exhibits and meet building codes.
FHA 203(k) loan pros and cons
Like any mortgage, there are advantages and disadvantages to an FHA 203(k) loan.
- One loan for both purchase and renovations
- Low minimum down payment requirement
- Relatively low credit score requirement
- Potentially lower interest rates compared to personal loans, credit cards or other home improvement loans
- Covers mortgage payments if the home can’t be lived in during renovations
- Mortgage insurance required
- Rates may be higher compared to conventional loans
- May require oversight by HUD consultant
- More extensive repairs require more paperwork
- Potential for the additional cost of architectural assessments
FHA 203(k) loan qualifications
The main restriction for an FHA 203(k) loan is that the borrower has to be the owner or occupant. Investors are not eligible for this kind of loan, although in certain situations, nonprofit organizations may be allowed to obtain one. Other qualification criteria include:
- A minimum credit score of 580 or higher
- 3.5 percent minimum down payment
- Maximum 43 percent debt-to-income ratio
As with other FHA programs, it’s possible to have a credit score as low as 500 if your down payment is at least 10 percent. Keep in mind that many lenders require a minimum credit score of 620 or higher, even though the FHA minimum is lower.
There are also minimum energy-efficiency and structural standards that the project must meet in order to qualify.
FHA 203(k) loan rules
FHA 203(k) loans come with some other strings attached. For one, the work must begin within 30 days of closing and be completed within six months. The FHA limits the projects to structural alterations and reconstruction, and modernization and improvements to the home’s function.
“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.”
The contractor you work with should be familiar with this kind of loan, especially the payment schedule and requirements. Be sure to ask the contractors you’re considering about their experience with 203(k) loans.
When the renovations are completed, you as the borrower are required to provide a letter, and a HUD-approved consultant will conduct an evaluation of the work. Consultants can be found through a lender or via the FHA website.
A 203(k) loan can cover many projects. 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 appearance and eliminate obsolescence
- Reconditioning or replacing plumbing (e.g., 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 disabled person
- Making energy conservation improvements
- Conversion from a single-family to multifamily property (maximum of four units), or vice versa
What isn’t allowed
Work on certain kinds of properties, such as co-ops, is not allowed to be financed with a 203(k) loan. Mixed-use properties with both commercial and residential space may be eligible if the work being done is solely for residential usage.
There are also projects that don’t qualify for 203(k) financing. 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 a 203(k) loan to pay for it.
Examples of projects the loan won’t cover include luxury add-ons, such as:
- Swimming pool
- Hot tub
- Tennis court
- Barbecue pit
- Outdoor fireplace
- Satellite dish
Cost of an FHA 203(k) loan
Closing costs for FHA 203(k) loans are similar to other mortgages and refinances, typically 2 to 7 percent of the sales price of the home. However, some lenders may charge supplemental fees for this type of financing.
The FHA sets the rules on which closing costs can be paid by the borrower. All other costs are usually not allowed and are the seller’s responsibility, or the lender’s if you’re refinancing an existing loan.
Some costs you can expect to pay include:
- Lender origination fee
- Appraisal and inspection fees
- Title insurance and title search
- Credit report check
- Property survey
A 203(k) loan also requires an upfront mortgage insurance payment of 1.75 percent of the total loan amount, which can be wrapped into the financing. You’ll also pay a monthly mortgage insurance premium based on your loan-to-value ratio and length of the mortgage.
How to find an FHA 203(k) loan lender
The Department of Housing and Urban Development’s lender list lets you search for mortgage companies offering FHA 203(k) loans in your area.
FHA 203(k) loan refinancing
FHA 203(k) loans can be used both 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 for homeowners looking to renovate. Among the others:
- Home equity lines of credit – HELOCs come with 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 loans – This type of mortgage also allows you to borrow against the future value of your home.
- Cash-out refinance – In this scenario, you borrow more than you owe on your existing mortgage and apply the proceeds to renovations. This requires equity in your home.
- Construction loan – A home construction loan is a short-term, higher-interest loan that provides the cash to pay the contractors. The property owner typically needs a longer-term mortgage after the work is completed.
- 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, Noah, 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.
If you’re looking for affordable financing to remodel or upgrade your home, whether you’re a longtime homeowner or a first-time homebuyer, an FHA 203(k) loan may be a good option. Do some comparison shopping to determine what will work for you and to find the best FHA lender for your situation.