If you’re angling to buy a home at a price you can afford, you may consider making some compromises, like looking outside your dream neighborhood, for example. You might also need to consider homes that aren’t in perfect shape, or even ones that require a complete overhaul. Fortunately, some mortgages allow you to wrap the costs of a remodeling project into the loan. This could be true when you use this type of mortgage to purchase a property, or when you decide to remodel a home you already own and refinance to access funds for your project.
The Federal Housing Administration (FHA)’s 203(k) rehab loan is a popular option that works in these scenarios. This type of loan allows homeowners to roll remodeling funds into their primary mortgage.
In this guide, we’ll go over the following details to explain how the 203(k) loan works:
What is a 203(k) loan?
Imagine you want to purchase a $100,000 home that needs a minimum of $20,000 in upgrades and repairs to make it habitable, clean and safe. You could purchase the home and move in until you can finance the improvements separately, but you could also take out a 203(k) rehab loan that covers both the initial mortgage amount and the cash you need for repairs.
While many consumers use the 203(k) loan for purchases, also note these loans work for refinancing as well. In other words, if you already own your home but need cash for important updates and improvements, you could refinance your current mortgage with a 203(k) loan and borrow additional funds to pay for the repairs.
The 203(k) loan program offers two versions that work best for different situations:
- The Standard 203(k) is perfect for updates and repairs, although there is a minimum repair cost of $5,000 and you have to work with a 203(k) loan consultant to complete the process.
- The Limited 203(k) is for modest upgrades and repairs. This loan does not require you to use a 203(k) consultant, but the maximum repair cost cannot exceed $35,000. There is no minimum repair amount for this type of 203(k) loan.
Generally speaking, 203(k) loans can be used for projects that increase the value of your home, make it safer or improve structural integrity. The FHA lists the following eligible activities for loan funding on its website:
- Structural alterations and reconstruction activities
- Improvements to a home’s function or utility
- Improvements that improve health or eliminate safety hazards
- Changes that improve a home’s appearance
- Replacing or repairing plumbing, a well or a septic system
- Replacing or repairing roofing, gutters or downspouts
- Replacing or adding flooring
- Major site improvements or landscaping projects
- Improvements that make homes accessible for people with a disability
- Energy-use improvements
Eligibility for using a 203(k) rehab loan
While 203(k) loans tend to offer flexible terms for both borrowers and the homes they suit, they do come with some basic requirements.
Property eligibility requirements
For a property to qualify for a 203(k) rehab loan, it must have been completed at least one year before it is assigned a case number. This means 203(k) loans cannot be used for brand-new construction that is less than 1 year old. Other property requirements for 203(k) loans include:
- Must be a one- to four-unit building of single-family homes
- Can be a condominium if it is in an FHA-approved condominium unit; improvements are limited to the interior of the unit in most cases, and the unit is in a building with no more than four units
- Can be manufactured housing if the upgrades and improvements do not affect the structural components of the building
- Can be a mixed-use property with one to four residential units, provided at least 51% of the unit is residential
- The home cannot exceed dwelling-unit limitations for the area
- The home must be located in the United States.
Borrower eligibility requirements
There are also borrower eligibility requirements for 203(k) loans. These requirements determine who is eligible and under what circumstances.
To qualify for a 203(k) loan, you must:
- Have a valid Social Security number (unless you are a state or local government agency, instrument of government or nonprofit approved by the U.S. Department of Housing and Urban Development, or HUD)
- Be able to provide the lender with your SSN, name, date of birth, original pay stubs, W-2s, valid tax returns and any other required information to obtain a mortgage
- Have a minimum credit score of 500
- Be a U.S. citizen or an eligible noncitizen
- Not have any delinquent federal tax debt
- Not have a delinquent FHA home loan
- Must live in the property as a principal residence.
How to get an FHA 203(k) rehab loan
To determine eligibility for an FHA 203(k) loan, you’ll need to search for a lender that’s approved to offer FHA loans. Fortunately, HUD offers a tool on its website that allows you to search for FHA-approved lenders in your area. It even includes a featuring of searching only for lenders that have dealt with a 203(k) rehab loan in the last 12 months.
If you plan to apply for a Standard 203(k) rehab loan, you’ll need to work with a 203(k) consultant. This consultant, who must meet stringent requirements in terms of their work experience and licensing, will inspect the property and prepare the architectural paperwork, work write-up and cost estimate for your project.
The FHA 203(k) consultant is also charged with overseeing the renovation funds, which are initially placed in an escrow account. Your consultant is able to sign off on when these funds are released to contractors and service providers working on your project.
Pros and cons of an FHA 203(k) loan
FHA 203(k) rehab loans come with both advantages and disadvantages. Some reasons to consider these loans are listed below, along with some of the pitfalls that make them a less attractive option.
Pros of FHA 203(k) loans
- FHA loans have low credit-score requirements: You can qualify for an FHA 203(k) loan with a credit score as low as 500. It’s a much lower minimum standard credit score than many other types of home loans.
- Wrap your remodeling costs into your home loan: The biggest benefit of FHA 203(k) rehab loans is that you don’t have to pay for remodeling costs out of pocket. You can wrap the costs of your project into your primary home loan instead.
- Interest rates are typically lower than some other mortgage options: FHA loans also come with low closing costs, and FHA interest rates may be lower than some other types of home loans.
Cons of FHA 203(k) loans
- Standard 203(k) loans require you to work with a loan consultant. Not only can working with a 203(k) loan consultant cost up to $1,000 in fees for the service, but this layer of work adds yet another step to the process. Remember that your 203(k) loan consultant will have to complete an inspection of the home, sign off on all improvements and their costs and address any health and safety issues.
- Government-backed loans tend to come with a lot of rules. Government-backed FHA loans have many rules, and FHA 203(k) loans are no exception. For example, you cannot use this type of loan for “luxury items” including hot tubs, outdoor fireplaces or swimming pools.
Alternatives – other renovation loans
As you dig deeper into the prospect of taking out an FHA 203(k) rehab loan for home improvements, don’t forget there may be other options that work for your situation. Some 203(k) loan alternatives include:
- Fannie Mae HomeStyle® Renovation: Fannie Mae’s HomeStyle Renovation loan is another type of home loan that lets you include renovation and repair costs in your mortgage amount. These loans tend to offer competitive rates that can be lower than those you can get with a home equity loan or home equity line of credit (HELOC), and they work for the purchase of a home as well as refinancing an existing home.
- Home equity loan: A home equity loan lets you borrow against the equity in a home you already own to free up funds for repairs, renovations or any other type of spending. This type of loan comes with a fixed interest rate, fixed monthly payment and fixed repayment timeline.
- Home equity line of credit (HELOC): A HELOC is a line of credit that works similarly to a credit card except but is secured by the equity in your home. These loans have fluctuating monthly payments that vary based on how much you borrow, as well as variable interest rates.
- Personal loan for home improvement: Also be aware that you can take out an unsecured personal loan for home improvements. Like home equity loans, these loans come with a fixed interest rate, fixed monthly payment and fixed repayment timeline.
If the home you love needs some love, it’s nice to know there are plenty of ways to access the cash you need. Compare your options, including 203(k) rehab loans, and weigh the pros and cons of each before you decide.