203k Loan: Rehab Loans Courtesy of the FHA

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The Federal Housing Administration’s 203(k) loan is a mortgage that could turn your lofty goal of renovating a fixer-upper home into a reality. The loan program helps homebuyers finance both the purchase of a property and the cost of renovation into one mortgage. In this post, we’ll discuss:

What is a 203(k) rehab loan?

The 203(k) loan offers both fixed-rate and adjustable-rate mortgage options for your purchase (or refinance) and rehab. There are two types of 203(k) rehabilitation mortgages — the standard 203(k) and limited 203(k).

The standard 203(k) loan is for major remodeling and repairs. The minimum cost of the repairs must be $5,000. For this loan, you’re required to work with an FHA-approved 203(k) loan consultant who inspects your property, develops the renovation plans and estimates the cost of the work.

The limited 203(k) — also called the streamline 203(k) loan — is for smaller remodeling projects. To qualify, your repair and rehab costs must be below $35,000. Working with a 203(k) consultant is not required for this loan.

Eligibility requirements for the 203(k) rehab loan

Credit, down payment and debt-to-income ratio. A credit score as low as 500 may be enough to get approved for a 203(k) loan, but a higher credit score will likely get you better terms. You’ll generally need a debt-to-income ratio (how much debt you owe compared to how much income you earn) of 43%. Lenders may accept as little as 3.5% down, depending on your credit.

Property age and type. The home has to be at least a year old. You can use a 203(k) loan for one- to four-unit single family structures or mixed-use property. Mixed-use properties have to be at least 51% residential. Condos and mobile homes may be eligible as long as certain conditions are met.

Property value. The total property value has to be within the FHA limits for your area. Property value is calculated as the value of the existing home plus the renovation costs, or 110% of the appraised value after the renovations, whichever is lesser. Check out the FHA loan limits here.

What renovations can you use the 203(k) loan for?

The standard 203(k) loan and limited 203(k) loan have different rules for how you can use the funds.

Standard 203(k): This loan cannot be used for luxury items like a new swimming pool, hot tub, tennis court or barbecue pit. You can use the loan for major renovations such as converting a one-family to a two-, three- or four-family home, rehabbing a garage or making improvements to modernize the home, its functions and landscape.

Limited 203(k): This loan also cannot be used for luxuries. The loan can be used for minor repairs. Major repairs that do not qualify for the limited 203(k) include:

  • Any repair that requires over six months to complete
  • Any work that requires more than one payment per contractor
  • Repairs where the borrower can’t live in the home for over 15 days
  • Repairs that require extensive plans or a consultant

Advantages and drawbacks to using an FHA rehab loan

There are a number of pros and cons to an FHA rehab loan compared to a conventional loan.

The advantages

  • Accessibility, convenience and opportunity. According to the Department of Housing and Urban Development, the 203(k) rehab loan fills a gap for homeowners who may struggle to find affordable and uncomplicated renovation loans elsewhere. The purchase (or refinance) and remodel costs are bundled into one easy-to-manage payment. Current homeowners and homebuyers may find that using this loan for renovations increases home value and pays off long-term.
  • Manageable upfront costs. You may be able to bring as little as 3.5% down to the deal table. Some fees may be rolled into your loan, such as a portion of your origination fees and discount points.

The disadvantages

  • Mortgage insurance. FHA loans have mortgage insurance that’s paid upfront and annually. Upfront mortgage insurance is currently 1.75% of the base loan amount. You may be able to finance upfront insurance into the mortgage. Annual mortgage insurance premiums can range from 0.45% to 1.05% depending on your loan amount and loan term length.
  • Loan use limitations. The rules for what you can use the 203(k) loan for are fairly open. But there may be instances where what you want to build or remodel is not eligible. For example, a new underground swimming pool won’t qualify.

How to get a FHA 203(k) rehab loan

The first steps to getting a 203(k) loan are shopping for an FHA-approved lender and then starting the home search. Next, if it’s required, you should look for an approved 203(k) consultant to write up the plan for your renovation and estimate the cost of the work that needs to be done.

Afterward, shop around for contractors who can do the work within the price range of the estimate given by the consultant. The contractor has to be approved by the lender. In certain circumstances, you may be able to act as your own general contractor as long as it’s approved by the lender. You must list out your labor costs; only the costs of materials will be reimbursed.

Finally, an appraisal is done and closing happens, assuming the deal goes through. Money for the rehab is put into an escrow account after closing. The lender will distribute funds from the escrow account to contractors as the repairs are completed.

Renovation loan alternatives

Maybe you don’t want to pay for the ongoing home insurance required by an FHA loan, or you want a loan with fewer renovation restrictions. There are a number of other options that might be a better fit.

Fannie Mae HomeStyle Renovation

A Fannie Mae HomeStyle Renovation loan is a product like the 203(k) that can be used to finance renovations with a home purchase or refinance. The down payment may be as low as 3%. The loan also has fewer renovation rules. Any type of renovation qualifies, as long as it’s fixed permanently to the property. The contractor doing the work must also be approved by the lender.

However, your eligibility requirements may be a bit stricter than with an FHA 203(k) rehab loan. For instance, you’ll likely need a 620 credit score or better to qualify.

Home equity loan or home equity line of credit (HELOC)

Home equity products are a way to tap into your existing home equity for renovations. Home equity loans are installment loans, while HELOCs are credit lines where you can withdraw money up to a limit. A disadvantage of using either one of these home equity products is that the amount you can borrow is limited to the available equity. Lenders will usually let you borrow up to 85% of your home equity, although eligibility conditions apply.

Cash-refinance

A cash-out refinance is when you refinance a mortgage for more than your loan balance and you take cash out of the transaction. For example, if your loan balance is $150,000, you can refinance the mortgage for $175,000 and get $25,000 for renovations. A cash-out refinance is most worthwhile if it kills two birds with one stone — it gets you the cash you need and has better loan terms than your existing loan.

Renovating isn’t a dream that’s out of reach

Making home upgrades is possible, even if you don’t have the funds to pay out of pocket. FHA 203(k) rehab loans may be a good option for you if you have trouble qualifying for a conventional loan, but you’ll likely pay more in interest and possibly insurance costs. Explore and compare your options to determine what the right fit is for your next project.

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