FHA 203(k) Loans: What They Are And How They Work

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What is an FHA 203(k) loan?

An FHA 203(k) loan, also known as an FHA 203(k) rehab loan or Section 203(k) loan, combines the financing for a home’s purchase and remodeling or repairs into a single loan. Along with these costs, you can also use a 203(k) loan to finance up to six months of mortgage payments while you live elsewhere during renovations. Like other FHA loans, a 203(K) loan is insured by the Federal Housing Administration and offered by FHA-approved mortgage lenders. It also comes with the requirement to pay FHA mortgage insurance.

There are two types of FHA 203(k) loans: limited 203(k) and the more popular standard 203(k). Here’s an overview:

Types of FHA 203(k) loans

How does an FHA 203(k) loan work?

A 203(k) renovation loan can be a 15- or 30-year fixed-rate or adjustable-rate mortgage (ARM). The amount you can borrow depends on criteria such as your credit rating and income. 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
• The home’s before-renovation value plus improvement costs
• The home’s after-renovation value

What can an FHA 203(k) loan be used for?

A standard 203(k) loan can cover many major projects, including:

• Converting a property from one unit to up to four units, or the reverse
• Foundation repairs
• Adding or repairing a deck, patio or porch
• Adding or remodeling a garage
• Adding a fence
• Adding accessibility features for people living with disabilities
• Installing appliances such as a new refrigerator, cooktop or oven
• Remediating health and safety hazards, such as lead paint

This type of loan can’t cover improvements such as adding a gazebo, swimming pool or tennis court. You also can’t use it for repairs to co-ops or mixed-use properties, unless that property is primarily residential.

A limited 203(k) loan, in contrast, can cover projects like:

• Renovating a kitchen
• Painting interiors
• Replacing old carpeting
• Preparing a home for sale

FHA 203(k) loan requirements

There are many requirements to qualify for an FHA renovation loan, including:

• Occupation – The main restriction on an FHA 203(k) loan is that the borrower has to be the owner-occupant of the home. Investors are not eligible for this kind of loan, although, in certain situations, nonprofit organizations might be allowed to obtain one.
• Credit score and down payment – You’ll need a minimum credit score of 580 with 3.5 percent down, or a minimum score of 500 with a 10 percent down payment.
• Debt-to-income (DTI) ratio – Your debt-to-income (DTI) ratio, which measures your gross monthly income against your monthly debt payments, can’t exceed 43 percent.
• Renovation rules – You can only use a limited 203(k) loan for non-structural renovations costing up to $75,000. For a standard 203(k) loan, the work has to involve major construction and cost at least $5,000.
• Timeline – For the standard 203(k) loan, the work has to be completed within 12 months of closing. For a limited 203(k) loan, the work has to be completed within nine months of closing.

FHA 203(k) loan pros and cons

An FHA 203(k) loan allows you to purchase a home that needs some work without obtaining two loans. However, there are many rules for qualifying for this type of mortgage.

FHA 203(k) loan vs. construction loan

An FHA 203(k) loan funds the purchase of a home and qualifying renovations, while a short-term construction loan funds renovations only. Once the project is complete, you can convert the construction loan to a regular mortgage. Depending on your credit and finances, a 203(k) loan might be easier to qualify for, but a construction loan has fewer restrictions around the types of improvements you can finance.

Are FHA 203(k) loans a good idea?

An FHA 203(k) loan can be useful if you want to fix up a new home to live in, but you’re struggling to get approved for conventional funding. As government-backed loans, FHA 203(k) loans are typically easier to qualify for than conventional mortgages.

“If the house you are looking at buying needs significant work, and you intend to live in the home, not flip it or use it as an investment, then this could be a good loan option for you,” says Aaron Craig, vice president of Mortgage Sales for Georgia’s Own Credit Union.

However, since FHA 203(k) loans require extra work and oversight, they aren’t the right choice for everyone. For some people, it can be challenging to estimate their renovation costs and project timelines and ensure they align with the FHA’s requirements.

“I would only recommend FHA 203(k) loans to those who know the construction industry and are not first-time buyers, as it’s a complex loan and takes a lot of coordination,” says Kevin Watson, a Nashville-based senior home loan specialist for Churchill Mortgage.

“You hear stories about some unscrupulous lenders out there making these sound easy, but I think that does a disservice to the borrower, as they are complicated and should be approached with caution,” Watson says.

How to get an FHA 203(k) loan

Once you’ve identified a home to buy and fix up, you can apply for a 203(k) loan with your lender and start working on your home projects. The process involves the following steps:

1. Assign a consultant, if needed: If you’re obtaining the standard version of the loan, your lender will assign a 203(k) consultant to your project. If you’re getting the limited 203(k), you’re not required to work with a consultant.
2. Work with a contractor: Once your lender signs off on the consultant’s details and closes the loan, you’ll work with a licensed contractor to handle renovations.
3. Have the work completed: Your lender will issue payments to you at various phases of the renovation. As the project progresses, the consultant will inspect the work to authorize more payments.
4. Wrap up the project: Once the project is finished, you’ll provide a release letter and the consultant will evaluate the work.

FHA 203(k) loan refinancing

You can use an FHA 203(k) loan to 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 a mortgage escrow account until repairs are completed. You can also refinance an existing 203(k) mortgage through the FHA streamline program, which may help you get an even lower interest rate.

FHA 203(k) loan FAQ

• What types of properties are eligible for an FHA 203(K) loan?
  

  An FHA 203(k) loan can be used for single-family homes (including homes with accessory dwelling units, or ADUs) and multifamily homes with up to four units. It can also be used for an eligible condo or manufactured home, or a townhome. You might be able to use it for a mixed-use property, as well, provided the property is majority-residential.

• Can I do the renovations myself for an FHA 203(k) loan?
  

  If you’re qualified — say, a licensed general contractor — you might be able to do some or all of the work yourself. You cannot reimburse yourself for labor costs with the 203(k) loan proceeds, however.

• Can I use an FHA 203(k) loan for purchasing a property in need of a complete rebuild?
  

  An FHA 203(k) loan allows you to use funds for everything from minor repair needs to nearly the entire reconstruction of a home, as long as the original foundation is intact.

Additional reporting by Taylor Freitas