203k Loan: Rehab Loans from the FHA

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Sometimes, even an almost-perfect house needs work. It may be the newly listed house you’ve been eyeing for years that still needs a kitchen overhaul. Or perhaps it’s your current home, which needs new floors or updated plumbing.

For times like these, many homeowners — as well as soon-to-be owners — turn to an FHA 203(k) loan to get the renovation funds they need. We’ve created a guide to help you understand this government-backed loan program. Read on to learn how a 203(k) loan works and why it may be the right choice to help you complete those renovations that, well, really could make your home perfect.

What is an FHA 203(k) loan?

An FHA 203(k) loan is either a fixed-rate or adjustable-rate loan that pays for a sizable home improvement. It can be used to pay for just a renovation or a renovation combined with either the purchase of a new home or a refinance of an existing home. With the second option, the loan allows you to avoid having to take out two separate loans, saving both time and money, since an FHA loan may be able to give you a better interest rate (and longer repayment terms) than what you might receive with a private loan. Another benefit: By giving you access to more cash upfront (see below), you may find yourself better able to juggle home costs, especially if you have major improvement needs.

You can choose from two types of 203(k) loans, depending on the size of your renovation project:

  • The standard 203(k) loan: This loan may be used for remodeling and repairs, provided the project cost is at least $5,000 and a 203(k) program consultant is used.
  • The limited 203(k) loan: This loan may only be used for minor remodeling and non-structural repairs. There is no minimum repair cost, but cost of the repairs must not exceed $35,000. A consultant may be used but is not required.

Eligibility requirements for a 203(k) loan

Borrower eligibility

For the most part, borrower requirements for a 203(k) loan are the same as for any FHA loan. If you have a credit score of 580 or higher, you should be eligible to put as little as 3.5% down. If your score is between 500 and 579, you’ll need to put 10% down.

Still, depending on the lender you use, you may be subject to additional requirements.

“Some lenders include stricter qualifying requirements because there’s a lot of trust that has to go into giving out money ahead of the repairs and relying on the borrower to do what they say they’re going to do,” said Corey Vandenberg, a mortgage consultant with Platinum Home Mortgage in in Lafayette, Ind.

Project eligibility

You can use an FHA 203(k) for a very wide range of improvements, and even to rebuild a home that’s been demolished or scheduled to be demolished, as long as the foundation is still up.

The following projects are eligible under the standard 203(k) program, provided the home being worked on is at least a year old. The home must also be the borrower’s primary residence and a one- to four-unit structure.

  • Structural alterations
  • Eliminating health and safety hazards
  • Wells and/or septic systems and sewage systems
  • Plumbing, electrical work and HVAC
  • Improving function and modernization
  • Aesthetic changes
  • Roofing, gutters and downspouts
  • Energy conservation improvements
  • Accessibility accommodations for persons with disabilities
  • Fences, walkways and driveways
  • Installing new appliances

To be eligible for a limited 203(k) loan, you may face additional restrictions. For example, you can’t use the loan for repairs that take more than six months to complete; any repair that prevents the borrower from inhabiting the property for more than 15 days; any work that requires more than two payments to the same contractor; and any renovation that requires plans or specifications from an FHA 203(k) consultant or architect.

Also worth knowing: Both 203(k) loan types won’t allow you to repair or install luxury items like a new pool, hot tub, sauna, outdoor fireplace or gazebo.

The advantages and drawbacks of an FHA rehab loan

Advantages:

Simpler financing structure: The Federal Housing Administration set up the 203(k) loan program to help consumers avoid the higher interest rates and shorter repayment terms that often come with both buying and renovating a home that needs significant work.

Access to more financing: According to mortgage consultant Corey Vandenberg, the big advantage of a 203(k) loan is that it gives you access to more financing based on the projected appraised value of the home, instead of its current appraised value. With a 203(k) loan, you can finance up to 110% of your home’s value. By contrast, if you were to take out a second mortgage to pay for repairs, you might be able to access no more than 90% of your home current value.

Less strict borrower requirements: The FHA credit minimums of 580 or 500, depending on the down payment you’re prepared to make, are much lower than those for comparable conventional loan options. For conventional loans, the minimum credit score typically falls between 620 and 640.

Disadvantages:

Extensive approval and documentation are required: When you’re approved for a 203(k) loan, you’re given more money than the property you’re renovating is currently worth, so these loans are riskier for lenders. They compensate for the added risk by requiring that every step of the process be documented and approved before you can move forward.

Limits and restrictions are common: As stated earlier, 203(k) loans limit the type of work that can be financed, and they may not be right if you’d like to include luxury items in your renovation. Your loan amount will also be subject to the FHA loan limits in your area.

How to get a 203(k) rehab loan

The loan process

According to Vandenberg, applying for a 203(k) loan is similar to applying for any other FHA loan, with a few small exceptions. Here is what he recommends:

  • Get a preapproval: It’s possible to be preapproved for more than one loan at a time, so start the process if you think you may be looking at homes that require a lot of work, even if you haven’t found the exact home yet.
  • Present an offer: When you submit an offer, you’ll have to include your preapproval so the seller knows you intend to follow 203(k) loan processing guidelines.
  • Schedule a feasibility study: During a feasibility study, your contractor will visit the property to track the work that needs to be done and prepare the official work plan that needs to be submitted as part of your application.
  • Make sure you get an appraisal: An appraisal will let you and your lender know what your home will be worth after the renovations are done.
  • Expect a normal underwriting process: After the steps above are completed, your loan will be processed just like any other loan, though additional documentation often needs to be submitted.
  • Look for funds at closing: At closing, you’ll receive your first draw on the funds allocated for the renovations, and an escrow account will be created to hold the rest.
  • Start renovating: After closing, renovations can officially begin. As the borrower, you and your consultant (if you’re required to use one) will be responsible for making sure the project stays on track and is completed by the specified date on the loan agreement.

What are the limits on what you can borrow?

Limited 203(k) loan: There is no minimum amount, but your total renovation costs may not exceed $35,000.

Standard 203(k) loan: The project must cost at least $5,000 and may go up to one of the following:

  • The as-is value of the home plus the cost of renovations
  • 110% of the projected value of the home once renovations are completed
  • The FHA lending limits in your area

How long does it take to get a 203(k) loan?

Although there is more paperwork with a 203(k) loan than with a standard FHA loan, you’re held to tight timeframes throughout the process, which keeps the review process moving.

As a result, “these loans don’t take any longer than usual to close,” Vandenberg said. “It’s not unusual to expect yours to close within 30-45 days.”

Using a 203(k) consultant

By working with a 203(k) program consultant, you’ll be able to hand off paperwork to someone else. Your consultant is a licensed engineer, architect or home inspector who is in charge of overseeing every part of the project from start to finish, as well as ensuring that the renovations will add value to your home once completed.

The FHA determines how much 203(k) consultants are paid. Depending on the cost of the renovation, they’re allowed to charge between $400 and $1,000, and $100 extra if they also need to do a feasibility study or prepare a change order request for your renovation. Re-inspections are $50.

Alternatives to a 203(k) loan

If an FHA 203(k) loan doesn’t sound right for you, there are many alternatives you can choose from:

Fannie Mae HomeStyle renovation loan

Conventional loans have an answer to the FHA 203(k) loan, and it’s known as the Fannie Mae HomeStyle renovation loan. Like a 203(k) loan, it allows more access to financing because the appraisal is based on the home’s value once renovations have been completed. However, unlike FHA’s renovation loan, this loan allows for both luxury items and investment properties.

According to Vandenberg, the loan also doesn’t require that borrowers pay private mortgage insurance (PMI) once they’ve paid off 78% of the value of their loan. With an FHA loan, he cautioned, borrowers pay private mortgage insurance over the life of the loan.

The tradeoff: Expect stricter qualifying requirements with a Fannie Mae HomeStyle renovation loan, like a credit score requirement of 620 to 680, depending on your loan-to-value (LTV) ratio.

Home equity loans, home equity lines of credit and cash-out refinances

Home equity loans and home equity lines of credit allow you tap into the equity you’ve built up in your home for funds. According to Vandenberg, they’re a good option for renovating existing properties, but they can’t be used if you’re looking to both buy and renovate a new home. The other drawback: Home equity loans use an appraised value that’s based on what your home is worth now, not what it will be once renovations are done.

A cash-out refinance lets you refinance for more money than you currently owe on your mortgage, which allows you to roll both the cost of your mortgage and renovations into one loan. However, it doesn’t work for newly purchased properties and might cause you to have a longer mortgage term.

The bottom line

An FHA 203(k) loan is a good option for financing both large and small home renovation projects. However, the loan comes with numerous rules and restrictions, which you’ll need to research carefully. Armed with that knowledge, you can decide whether this type of FHA loan is right for you, or whether an alternative might be better.

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