FHA 203(k) loans: What they are and how they work

When you buy a home, there are usually a few repairs to pay for. If you plan to take on a fixer-upper, you might be facing the prospect of many projects. If this is the case for you, you might be considering an FHA 203(k) loan.

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:

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 or repairing septic or well systems
• Adding a fence
• Adding accessibility features for those living with disabilities
• Installing appliances
• Landscaping
• 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. It also can’t be used for repairs to co-ops or mixed-use properties, unless that property is primarily residential.

A limited 203(k) loan, in contrast, can cover upgrades like new carpeting or paint.

FHA 203(k) loan requirements

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

• Occupation – The main restriction for 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 (RTI) 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 less than $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.

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, the lender will assign a 203(k) consultant to your project. The consultant will visit the home to estimate repair costs. 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. Ideally, this contractor should be familiar with 203(k) loans, especially the payment schedule and requirements.
3. Have the work completed: The process from here works like a regular construction loan: The lender issues payments to the borrower at various phases of the renovation. As the project progresses, the consultant will inspect the work to authorize more payments. You’ll have up to 12 months to complete the renovations if using a standard 203(k) loan, or up to nine months with a limited 203(k) loan.
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 escrow 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

• How is an FHA 203(k) loan different from a 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 less restrictions around the types of improvements you can finance.

• 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), duplexes, triplexes or another multifamily home 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.