FHA 203(k) Loan: How It Works and Loan Requirements

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Qualifying for a conventional loan can be difficult, especially if you’re trying to purchase a home that needs major renovation. Conventional mortgage lenders often hesitate to approve loans for these types of homes, leaving homebuyers to search for alternative sources, like hard money loans or private loans. 

A personal loan might be another alternative, but each of these types of loans has their challenges too. For instance, you may have to pay back the money in a shorter amount of time or get the loan at a steep interest rate.

Fortunately, through the Federal Housing Administration (FHA), homebuyers can take advantage of the 203(k) loan program. This type of renovation loan allows you to borrow money in excess of a home’s purchase price if the home you’re buying needs repairs. 

An FHA-approved consultant can help you understand whether this loan is right for you and what the FHA 203(k) loan requirements are.

If you’re not familiar with FHA loans, check out our YouTube video that explains FHA home loans and how they work.

What Is an FHA 203(k) Loan?

A typical renovation loan can help a homeowner finance home improvements they wouldn’t be able to afford otherwise. Many lenders offer renovation loans, but if you want to take advantage of the 203(k) loan program, you’ll need to speak with an FHA-approved lender. 

With this government-backed renovation loan, you can borrow money for major repairs or to make improvements that enhance the appearance of your primary residence.

You can add the extra loan amount to the mortgage for a home you want to buy, or you can refinance your home with a 203(k) rehab loan, and you don’t even need a current FHA loan to do so. You’re able to borrow up to 110% of the future value of your home or the purchase price, plus repair costs—whichever is less—as long as it’s within the FHA loan limit for your area. 

For example, if your home costs $300,000 and will require $25,000 in renovations, you can get an FHA 203(k) rehab loan for $325,000. 

There are two types of FHA 203(k) loans, both of which allow you to borrow up to the maximum conforming loan amounts for your area. Here are the details about each one:

Standard FHA 203(k) loan

The standard FHA loan for making home improvements to a single-family home requires borrowers to do at least $5,000 in repairs. This can include major structural repairs, energy conservation improvements, conforming to ADA requirements, or other significant repairs.

The FHA guidelines for the standard loan are very specific, and this loan requires you to use the expertise of a HUD-approved 203(k) consultant. This type of 203(k) loan is less common and requires more paperwork.

Limited FHA 203(k) loan

With the limited 203(k) loan, borrowers are typically doing nonstructural repairs. This might include replacing roofing, remodeling a kitchen or bathroom, or eliminating safety hazards around the yard. 

The limited loan caps out at $35,000, so any amount over this would be paid by you, the homeowner. This type of loan can be great for a home purchase when the unit needs cosmetic repairs or for someone who wants to refinance their existing mortgage so they have money to improve their property.

How Does an FHA 203(k) Loan Work?

Getting an FHA 203(k) loan is similar to getting any other home loan but with a couple of extra steps. It’s important to understand what the FHA 203(k) loan requires so you can decide if this is a loan that will work for you. 

We list the steps you should follow if you want to take advantage of using one loan to finance the purchase and repair costs of a home:

Shop around

The first step to getting approved for a 203(k) loan is to shop for the perfect lender because not all lenders are approved to offer FHA 203(k) loans. Get quotes, including interest rates, from a few lenders who offer this FHA program, and figure out who can get you the best deal. Then, apply for a loan and get a preapproval letter. 

You want to get preapproved by a well-known lender, such as one associated with Freddie Mac or Fannie Mae, as it will give you credibility when you’re shopping for a property.

Find a property

Once you have your preapproval letter, you can find a home you want to purchase and fix up. 

Let the seller know you’re getting an FHA 203(k) rehab loan when you make an offer. Part of the loan proceeds go to the seller, so they want to know where their money is coming from. 

Although many sellers prefer buyers who use a conventional mortgage, you may have an advantage in using a 203(k) loan if you’re buying a home that needs repairs. This is because the seller should understand it can be more challenging to get a loan for a home in disrepair.

Work with a consultant

Consider working with an FHA 203(k) consultant, especially if your renovation costs are expected to be north of $30,000. A consultant can get detailed proposals from professional contractors, including cost estimates and the scope of work required. 

If you’re planning to make repairs that cost more than $35,000, you’ll be required to use a 203(k) consultant approved by the Department of Housing and Urban Development.

Work with a contractor

You cannot renovate the property yourself if you want to get approved for an FHA 203(k) loan. You must hire a professional contractor. 

If you’re not working with a consultant, which isn’t required for the limited 203(k) loan, your contractor needs to draft a detailed proposal outlining the scope of work and the approximate cost. You’ll need to submit the proposal to your FHA lender if you want to ensure that you get the money to make your repairs.

Get a home appraisal

Your lender will issue a home appraisal to determine the property’s value before you buy it. 

Unlike a standard home appraisal you get with other FHA loans, when you apply for a 203(k) loan, you’ll get a report for the appraised value before and after renovations. This allows your lender to understand the risk involved with providing your loan. 

A home that will increase significantly in value with a few minor repairs will look better than a home that requires major structural repairs for only a small increase in its future price.

Close the deal

You can complete the transaction as long as the home appraisal is aligned with the proposed loan. Once you do, contractors must begin renovating your new or current home within 30 days. For a standard 203(k) loan, work must be completed within six months. 

Depending on the scope of the project, contractors are paid from an escrow account at the close of the loan and then again either at the completion of the project or at the completion of each major stage of the project.

Use the funds

After you have funds secured, you can use the money to make improvements to your home, complete a remodel, or do repairs that increase its value. Some borrowers use the loan to get their homes ready to sell, ensuring the residence is move-in ready for potential buyers. 

HUD lists the following approved activities for FHA 203(k) borrowers:

• Reconstructing or structurally altering a building
• Modernizing and improving the way a home functions
• Eliminating health and safety hazards
• Eliminating obsolescence and improving a home’s appearance
• Installing, replacing, or reconditioning the water system or plumbing
• Adding or replacing roofing, gutters, and downspouts
• Fixing or changing flooring or subflooring
• Completing landscaping or other major exterior improvements
• Making the property ADA-compliant
• Doing energy-efficient improvements

Your lender will guide you through this process because it also involves receiving bids from licensed contractors and some additional paperwork. However, that’s what your 203(k)-approved lender is there for—to help you turn your fixer-upper into a place to call home. 

How to Qualify for an FHA 203(k) Loan

FHA 203(k) loans are a subcategory of FHA mortgage loans and, therefore, have similar qualification requirements, including:

• You must live in the home. FHA 203(k) loans aren’t meant for house flipping.
• You must be a U.S. citizen or a lawful permanent resident. 
• You must make a 3.5% minimum down payment of the combined total of the purchase and renovation costs.
• You must have a minimum credit score of 580. In some cases, you may get a loan if your credit score is between 500 and 579 if you put 10% down, but it’s less likely. 
• You must have a debt-to-income ratio of less than 43%. In other words, if your pretax income is $4,000 monthly, your bills can’t exceed $1,720 a month. 
• You cannot exceed the FHA 203(k) loan limits in your area. These FHA loan limits vary by county.

FHA 203(k) Loan Pros

Every loan product has its pros and cons, and FHA 203(k) rehab loans are no different. Consider these pros to getting a 203(k) renovation loan for your home improvement project: 

A single loan

You can combine the purchase price of the home with the cost of home repairs in a single loan. This allows you to enjoy a newly renovated home without a monthly mortgage payment that exceeds your budget. 

Having a primary mortgage that fits your budget and a home that feels safe and comfortable can give you peace of mind and a sense of security.

Lower credit scores needed

With a 203(k) loan, you can purchase a home with a lower down payment and credit score than you can with a conventional loan. Your credit history won’t affect your ability to get this type of renovation loan as much as it would with a typical home equity loan. As long as buyers keep their credit scores in the 580 range and meet the other FHA loan requirements, they should have no trouble qualifying for a 203(k) loan.

Lower interest rates

Other types of home improvement loans, such as the HomeStyle Renovation loan and the CHOICEReno eXPress loan, may come with higher interest than a 203(k) loan. 

The interest rate you qualify for will depend on your credit score and other factors, but because you’re combining the mortgage and home improvement loan into one loan with one interest rate, you can get lower monthly payments. This is because you’re getting a 203(k) loan instead of a mortgage and a personal loan that each has interest.

Builds equity

Using an FHA 203(k) loan is a fast way to build equity in a home. The price of distressed homes is often much less than their nondistressed counterparts. So you can buy a home for less, use the benefits of the 203(k) loan program to fix it up and increase its value virtually right away. 

The equity you build by fixing up the home can be accessed through a cash-out refinance loan that can put money in your pocket. You can use the equity money to purchase another home as an investment or pay off debt to improve your credit.

Easier to find a property

Typically, there is less competition for a property that needs extensive repairs. This can open up a lot of opportunities for the right buyer. Purchasing a home that’s damaged with a loan that provides the extra funds to fix it up can mean getting a better house with lower mortgage payments. You can get in the home with a lower down payment as well.

FHA 203(k) Loan Cons

Using 203(k) loans isn’t for everyone. They have these downsides to think about:

Can’t be an investor…at first

You can’t get approved for an FHA loan if you’re looking for an investment property. One of the requirements for FHA loans is that the funds must be used to purchase a primary residence, not a home you plan to use as a rental property. This limits the potential for this type of loan.

However, you only have to live in the home for 12 months before you can sell it or rent it out. FHA 203(k) loans may be useful for house hacks with value adds or live-in BRRRRs, assuming you stay in the property for at least a year.

Have to pay PMI

You’ll need to pay private mortgage insurance (PMI) on the loan amount. Your lender will require mortgage insurance for an FHA loan because most borrowers put down less than 20% when using this type of loan. 

PMI limits the risk for the lender. This additional fee for mortgage insurance will add to your monthly mortgage payments.

More paperwork and time

Applying and being approved for an FHA 203(k) loan requires more paperwork than conventional loans, and it takes more time to close the deal. 

If your home needs significant repairs, you’ll have to use the limited loan. This means you have to use a 203(k) consultant to ensure that your home and the repairs won’t exceed your loan limit.

Higher interest rates

Typically, 203(k) rehab loans come at a rate of 0.75% to 1% higher than your standard FHA mortgage. Even though you can save on interest by combining your home purchase and renovation costs into a single loan, you’ll most likely pay a higher interest rate overall than you would with another home loan, in part because of the higher down payment requirement.  

Higher costs

Closing costs and other fees may be comparable to conventional loans, but you’ll need to determine what repairs will cost and make sure you budget for this when calculating the loan amount, which requires some footwork. 

Also, licensed contractors must do the renovations and repairs. You cannot DIY and save on costs. So you may pay more to get the property where it needs to be to live in it comfortably.

Does an FHA 203(k) Loan Sound Right for You?

For many, 203(k) loans are perfect because they allow homebuyers to purchase a home that needs repairs or make improvements to their existing home without having to come up with a huge down payment or take on a second mortgage. This FHA loan program helps homeowners eliminate health and safety hazards from around their homes without undue financial strain. These are improvements that can cost thousands of dollars or more.

However, 203(k) loans might not be right for everyone. For example, if the price of the home exceeds FHA loan limits, you won’t be able to qualify for this type of loan. Your loan limit can only be for 110% of the home’s value after renovations, so more expensive homes that also need major work done may not meet FHA requirements for mortgage loans. 

Discuss your options with your lender and financial advisor to decide if you can take advantage of an FHA 203(k) loan.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.