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203(k) Loan: How FHA’s Rehab Loan Works

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Buying a fixer-upper can be intimidating, but at a time when home prices are rising, it may be the only way for some homebuyers to afford the home they want. The Federal Housing Administration’s 203(k) loan is designed to help with those needs, by providing borrowers with the funds they need to purchase or refinance their home, plus make home improvements.

What is an FHA 203(k) loan?

An FHA 203(k) loan is a program backed by the Federal Housing Administration through which homebuyers can finance the purchase and rehabilitation of a home with a single mortgage. Current homeowners are also able to refinance and make home improvements with a 203(k) loan.

A portion of the loan is used to purchase the home or pay off an existing mortgage, and the remainder is placed in an escrow account to cover the rehab costs. A 203(k) loan can be a fixed- or adjustable-rate mortgage.

There are two types of FHA 203(k) loans: standard and limited.

Limited 203(k) loan

The limited FHA 203(k) rehab loan is geared toward minor improvements and repairs; no structural work is allowed. A 203(k) consultant (more on this below) isn’t required but can be used.

Standard 203(k) loan

The standard 203(k) loan is reserved for a major renovation or remodeling project and requires the use of a 203(k) consultant to oversee your home rehabilitation from estimate to completion.

The 203(k) consultant is a licensed architect, contractor, engineer or inspector who serves as a liaison between the buyer, contractor and lender, and files paperwork required by the FHA. A good consultant should be an asset to the borrower and ensure the home meets health and safety requirements, sort out disputes and keep the project on track. Your consultant signs off on the release of funds, which goes directly from the lender to the contractor or another service provider.

The borrower is required to choose and pay for the consultant, according to a fee table set by the FHA. Fees vary by the size of the project and range from several hundred dollars to more than $1,000. Borrowers can find approved 203(k) consultants on the U.S. Department of Housing and Urban Development’s website.

How much can you borrow with a 203(k) loan?

FHA 203(k) loan limits are imposed on the rehab costs for both limited and standard 203(k) loans — here’s a breakdown.

Loan Type  Minimum Cost  Maximum Cost 
Limited 203(k) loan $0 $35,000
Standard 203(k) loan  $5,000 Lesser of:

  • Purchase price plus rehab costs, or
  • 110% of the after-repair home value

Which improvement projects qualify?

For both types of 203(k) loans, work can be done on an eligible one- to four-unit property that is more than a year old.

The limited FHA 203(k) mortgage has a more narrow scope in terms of the home improvements allowed — for example, repairs can’t take longer than six months.

Some projects might include:

  • Installing a new roof
  • Painting the interior
  • Remodeling the kitchen
  • Repairing a well or septic system
  • Replacing the carpet

A standard FHA 203(k) loan covers a wide range of home improvement projects, including:

  • Altering the structure
  • Modernizing and improving functionality
  • Eliminating health and safety hazards
  • Upgrading the appearance
  • Replacing plumbing or installing a well or septic system
  • Adding or replacing roofing, gutters and downspouts
  • Adding or replacing floors
  • Major landscaping work
  • Enhancing accessibility for a person with disabilities
  • Making energy conservation improvements

Neither program allows what FHA calls “recreational or luxury improvements.” This includes installing features like a hot tub, tennis court or barbecue pit.

FHA 203(k) loan requirements

To get a 203(k) loan, you must meet the same requirements in place for a standard FHA loan.

  • Credit score and down payment. To contribute the minimum 3.5% down payment, you’ll need a 580 credit score. If your score is between 500 and 579, you must put down at least 10%.
  • Mortgage insurance premiums. You’ll pay upfront and annual mortgage insurance premiums. The upfront insurance is 1.75% of your loan amount and the annual insurance ranges from 0.45% to 1.05% of your loan amount.
  • Credit history. No foreclosures or deed-in-lieu of foreclosures within the last three years.
  • Lender. You’ll need to work with an FHA-approved lender.
  • Loan limits. Keep your total loan amount below the loan limit in your area. The 2020 loan limit for one-unit properties in most of the country is $331,760.

Pros and cons of an FHA 203(k) loan

As with any financial product, there are both benefits and drawbacks to using an FHA 203(k) rehab loan.

Pros

  • Since you’re combining the costs of buying and rehabbing your property into one loan, you don’t have to pay for renovations out of pocket.
  • You don’t need a perfect credit score and a large down payment to qualify for the FHA 203(k) program.
  • Interest rates may be lower than other forms of home improvement financing, such as an unsecured personal loan or credit card.

Cons

  • There are typically more fees involved than a standard mortgage. You’ll have upfront and ongoing mortgage insurance premiums. Additionally, appraisal fees might be as high as $700 and there are additional fees if a 203(k) consultant is required.
  • You must use the home as your primary residence.
  • FHA 203(k) loan limits are lower than conventional mortgages.
  • It could take months for your home to be move-in ready, so you may need to make other living arrangements during the rehab process.
 

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