What is an FHA 203(k) loan and do you need one?

Looking for a fixer-upper home? An FHA 203(k) loan might be the perfect accompaniment. A 203(k) loan, also known as a rehabilitation loan, is a mortgage backed by the FHA that lets buyers and homeowners purchase (or refinance) and renovate a home with one loan. It allows borrowers with imperfect credit, low down payments, and little equity to buy or refinance properties that need a little (or a lot) of TLC.

What is an FHA 203(k) loan and how does it work?

A 203(k) loan is a type of loan provided by lenders but backed by the Federal Housing Administration (FHA), with a few unique features. If you’re familiar with FHA loans, you know that the standard FHA loan for single-family homes helps buyers purchase a home with a small down payment.

A 203(k) loan also accepts down payments as low as 3.5%, while also allowing you to add the costs of renovations to your loan amount. You can even use an FHA 203(k) to refinance and renovate a home you already own.

“Think of this as a one-time close construction loan,” said Shashank Shekhar, founder of InstaMortgage. Instead of cobbling together multiple sources of financing to purchase the house and then renovate it, a 203(k) loan encompasses all of your financing.

There are two kinds of 203(k) loans: standard and limited. The limited version caps the renovation portion of the loan amount at $35,000, and can only be used on minor repairs and remodels. The standard version can be used on major construction and structural renovations that cost at least $5,000.

You can use the funds to bring the building up to code, modernize it, or upgrade its safety features. You’re not allowed to use the loan for luxury upgrades (like installing a new in-ground swimming pool). The mortgage amount is based on the expected value of the home after the renovation work is completed, and it includes the cost of the renovations.

With a 203(k) loan, the loan funds for the rehabilitation of the home go into an escrow account. As the contractor completes each portion of the renovations, the homeowner draws the necessary amount from the account for payment. If any money is left over when the work is complete, the remaining funds go toward the mortgage principal.

FHA 203(k) loan vs. FHA 203(b) loan

An FHA 203(b) loan is a popular type of loan for first-time homebuyers. It provides an affordable way for people to buy a home, even if they don’t have good credit or tens of thousands of dollars saved for a down payment.

You may be able to qualify for an FHA 203(b) loan with a credit score as low as 500. You can also use an FHA 203(b) mortgage to finance up to 96.5% of the value of the home. An FHA 203(b) loan is best for homes that don’t need a lot of work — those that are considered “move-in ready.”

On the other hand, if you’re shopping for a fixer-upper or a home that needs a lot of repairs and upgrades to make it safe and comfortable for daily living, an FHA 203(k) renovation loan may be the better choice. While it also allows for a low down payment and lenient credit requirements, like the 203(b), the 203(k) provides the additional benefit of allowing you to finance the mortgage and repairs with one loan. You don’t need to be a first-time buyer, either.

What home repairs are eligible for a 203(k) loan?

The government guides what repairs and upgrades you can spend your 203(k) home improvement loan proceeds on. These renovations include but are not limited to:

• Roofing upgrades: Repairing or replacing the roof, gutters, and downspouts
• Plumbing, HVAC, or electrical upgrades: Making fixes or upgrades to major home systems, including the plumbing, heating, cooling, and electrical systems, as well as installing a well or septic system
• Siding: Installing, replacing, or repainting the siding
• Building additions: Adding a second story or additional rooms
• Exterior living space: Adding a porch, patio, or deck
• Kitchen or bathroom renovations: Including new appliances, countertops, and fixtures
• Living space conversions: Turning an attic or basement into a livable space
• Safety improvements: This includes removing lead paint, repairing stairs and railings, and other safety improvements
• Energy efficiency improvements: Adding new windows, insulation, and heating systems to make the home more energy-efficient
• Accessibility improvements: Making adjustments that allow people with disabilities to use and move throughout their home with ease

Do you qualify for an FHA 203(k)?

While government-backed loans like an FHA 203(k) do have more lenient qualification criteria than conventional mortgages, there are still some requirements you must meet. Keep in mind that individual 203(k) lenders may have their own criteria as well.

These are the basic FHA 203(k) loan requirements:

• Credit score: For maximum financing (96.5% of the home’s value), you must have a credit score of at least 580; with a down payment of 10%, you can be eligible with a credit score of 500. If your credit score is less than 500, you are not eligible.
• Income limit: There is no income requirement for an FHA 203(k) loan.
• Debt-to-income ratio (DTI): Your front-end DTI (which compares your mortgage payment to your gross monthly income) cannot exceed 31%.
• Down payment: You need to make a minimum down payment of 3.5% (with a credit score of 580 or higher).
• Minimum repair cost: You must have at least $5,000 worth of repairs needed before you can use a 203(k) loan.
• Maximum loan amount: As with other FHA loans, the 203(k) is subject to certain loan limits, which vary based on where you live. For single-family homes, the limit ranges from $472,030 in a low-cost area to $1,089,300 in a high-cost area. Because construction costs are higher in Alaska, Hawaii, Guam, and the Virgin Islands, single-family home loans are capped at $1,633,950.
• Occupancy: You must be an owner-occupant to use a 203(k) loan.
• Age of home: The home must be at least a year old. This means you can’t use a 203(k) loan to build a new home.
• Mortgage insurance: FHA 203(k) loans require a mortgage insurance premium (1.75% of the loan amount) to be paid upfront.

Is an FHA 203(k) loan right for you?

FHA 203(k) loans have a lot of benefits, but they’re not for everyone. This kind of loan will be best if you’re looking to purchase and renovate a fixer-upper, have less-than-perfect credit, and are interested in making a small down payment. You can also use it to refinance a home you already own.

You won’t be able to use a 203(k) loan if you want to build a new home, are seeking to finance a home beyond the mortgage amount limits, or want money to make luxury upgrades.

FHA 203(k) loan FAQ

What is the maximum FHA 203(k) loan amount?

The maximum loan you can get with an FHA 203(k) rehab mortgage will depend on where you live. The U.S. Department of Housing and Urban Development (HUD) sets limits for low-cost-of-living areas and high-cost-of-living areas, acknowledging that home prices can vary greatly depending on what part of the country you’re home-shopping in. The maximum loan amount will also vary depending on the number of building units. Loans for single-family homes cannot exceed $472,030 in low-cost areas and $1,089,300 in high-cost areas. You can look up your area’s FHA loan limits using the HUD’s FHA mortgage limits page.

Do 203(k) loans have high interest rates?

Typically, 203(k) loans don’t have high interest rates and balloon payments, as compared to other construction loans. You can expect to pay about one percentage point more than you would with a typical FHA loan; loan rates can be fixed or variable, and they’re available in 15-year or 30-year terms.

Can I use a 203(k) loan for DIY renovations?

For the most part, you’ll need a licensed professional to complete renovation work under a 203(k) loan.

“You must hire professional contractors to work on the home, which can sometimes cause delays and frustrate homeowners,” said Shekhar. For some repairs, you may be able to do the work yourself, if you’re qualified. For standard 203(k) loans, you’ll also be assigned an FHA-approved consultant, who will help plan the work and sign off on cost estimates.

Are there limits on the property types eligible for a 203(k) loan?

A 203(k) rehab loan is generally used to help buyers fix up a home — usually a single-family home, but two-, three-, and four-unit buildings are eligible as well. These loans can also be used on condominium interiors, some manufactured homes, certain mixed-use properties, and HUD real estate-owned (REO) properties. While some local governments and nonprofits can use the program, typically commercial or investment properties will not qualify since the property must be the primary residence of an individual or a family.

Can I refinance an existing property with a 203(k) loan?

Yes, you can refinance a property you already own with a 203(k) loan, as long as you and the property meet the qualifying criteria. You can even refinance a 203(k) into a 203(b) once the renovation work is done. However, the main use of this type of loan is for buying and improving a new home.

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