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 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?

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 203(k) rehab loans. Rather, it provides financial protection to lenders that do.

How does an FHA 203(k) loan work?

A 203(k) renovation 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 for an FHA 203(k) renovation loan for 2022 continues to be 3.5 percent of the purchase price, or 10 percent if your credit score is below 580. 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

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.

Types of FHA 203(k) loans

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 qualifications for 2022

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 500 or higher
  • 3.5 percent minimum down payment or 10 percent if your credit score is below 580
  • 43 percent-45 percent maximum debt-to-income (DTI) ratio

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

Ways to use FHA 203(k) loans

FHA 203(k) loans come with some other strings attached. For one, the work must be completed within six months after closing, depending on the scope of the project. The FHA limits the projects to structural alterations and reconstruction, and modernization and improvements to the home’s function.

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.

Acceptable repairs

A standard 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 (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 disabled person
  • Making energy conservation improvements

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 percent to 6 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 (LTV) ratio and length of the mortgage

FHA 203(k) loan pros and cons

Like any mortgage, there are advantages and disadvantages to an FHA renovation loan:

Pros

  • 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

Cons

  • FHA mortgage insurance required
  • Rates may be higher compared to conventional loans
  • Process may require meeting with a 203(k) repair consultant
  • More extensive repairs require more paperwork
  • Potential for the additional cost of architectural assessments
  • Property must be your primary residence

How to find an FHA 203(k) loan lender

You can only obtain a 203(k) loan through an FHA-approved lender. HUD’s lender list allows you to search for approved lenders offering FHA rehab loans in your area. Because the application process and requirements associated with this type of loan can be complex, confirm the lender you select has experience with 203(k) loans.

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 or Freddie Mac CHOICERenovation loans – The HomeStyle loan and CHOICERenovation options also allow 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.

Bottom line

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.