Understanding the Qualifications and Drawbacks of FHA 203K Loans

Have you heard of FHA 203(k) loans? If you have, you almost certainly won't remember such an instantly forgettable name. But don't let that put you off. These can be hugely beneficial for those buying a fixer-upper or for those needing to repair their existing home, remodel its kitchen, bathroom or basement or otherwise improve it.

Like every other loan in the world, these aren't for everyone. And they sometimes have drawbacks that need to be taken seriously (see below). But for the right person in the right circumstances, they can seem heaven-sent.

Two Types of FHA Refurbishment Loans

The FHA offers two flavors of rehab loans (that's rehab for the home; not you) that might suit you if:

  1. You're buying a home that needs repairs or improvements. Indeed, you might even want to raze the building to the ground and rebuild on part of the existing foundations. Instead of having expensive short-term loans to cover the purchase and the cost of refurbishment until the property reaches mortgageable standards, you can have just one FHA 203(k) mortgage. This works equally well if you already own the home and wish to refinance in order to carry out a wide range of repairs and improvements, including extending the building.
  2. You wish to carry out alterations, repairs or site improvements, but don't want to go to the bother and expense of refinancing. These "Title 1" loans allow you to borrow between $5,000 and $25,000 for up to 20 years without refinancing. Indeed, you may be able to borrow up to $7,500 without any lien ("A creditor's legal claim against particular property owned by a debtor as security for a debt," according to NOLO) being registered. These Title 1 Home and Property Improvement Loans can be especially helpful to those who can't meet the more exacting personal credit and loan-to-value requirements of providers of home equity loans.

What It Takes to Qualify

To find out more about Title 1 loans, you can call the U.S. Department of Housing and Urban Development (HUD) on (800) 767-7468 and request item number 2651, "Fixing Up your Home and How to Finance It." The following information applies only to standard (not Title 1) FHA 203(k) loans. For those, you need:

  1. Reasonably good credit. Some suggest that a score below 640 might be problematical in getting approved at all, and, of course, the higher your score the lower the interest rate you're likely to be charged. To discover your score and to receive help improving it, check out LendingTree's entirely free credit score monitoring service.
  2. To be able to comfortably afford payments. You'll be asked to prove that your income is sufficiently large and your outgoings sufficiently small for you to be able to make payments without too much financial strain. In particular, your existing debt obligations will be examined, and lenders are likely to want to see that your total debt outgoings (including the new mortgage) make up 43 percent or less of your income.
  3. Your new mortgage to be within the FHA's current loan limits for your area.
  4. To require a loan in excess of $5,000, the minimum value for these.
  5. To have a fully costed estimate (labor and materials) from a professional contractor. You won't be able to do the work yourself unless you can show you're qualified.
  6. To be buying or refinancing an eligible home and to be carrying out work that's eligible. Most homes qualify for FHA support, and most alterations, repairs and improvements are covered. However, there are some exclusions, and you should discuss your plans with prospective lenders or visit HUD's website. Just don't expect to use the money for your new swimming pool or tennis court.
  7. The relationship between the value of your rehabilitated home and your mortgage to be within HUD's rules. Its website explains, "The value of the property is determined by either (1) the value of the property before rehabilitation plus the cost of rehabilitation, or (2) 110 percent of the appraised value of the property after rehabilitation, whichever is less."
  8. To ensure that, post-improvements, your finished home meets certain basic energy efficiency and structural standards specified by HUD.

What Are the Drawbacks?

The money for FHA loans (those backed by the Federal Housing Administration) is always provided by private lenders, and the government only guarantees part of the debt. That means rates and fees are likely to vary considerably, and it's important to shop around for the best deal. This is especially the case with 203(k) borrowing. The extra administration involved means some lenders won't touch them, while others manage them poorly. So take care choosing yours, and make sure its experienced in these particular products.

It's usually a little more expensive and time consuming to set up these loans than normal ones – though not usually as time consuming or expensive as setting up short-term loans and then replacing them with a fresh mortgage. The extra time and money is required partly because two appraisals are needed (one to determine the existing value of the home and another its likely value after improvements) and a final inspection of the finished work, but also because an escrow account must be established. With a purchase, money will be released immediately to pay the purchaser, and with a refinance to pay off the existing mortgage. The rest will go into that escrow account to pay your contractor when the project is completed. You need to alert the contractor to that when requesting an estimate or you may find your relationship with him or her rapidly deteriorating.

Are these drawbacks enough to put you off? Not likely if you're buying a fixer-upper or wanting to rehabilitate your home. FHA 203(k) loans may not be perfect, but, providing you qualify and choose a good lender, they can be much better, cheaper and easier than the normal alternatives.

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