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

Looking for a fixer-upper home? The Washington Post reported that in some markets, a fixer-upper could be priced “5 to 10 percent below comparable homes.” 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 private lenders but backed by the Federal Housing Administration (FHA), with a few unique features. Similar to standard FHA loans, a 203(k) loan helps buyers purchase a home with a small down payment.

A 203(k) loan also accepts down payments as low as 3.5%, while 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.

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.

Types of FHA 203(k) loans

There are two types of FHA 203(k) loans: standard and limited. Each has slightly different uses:

• Standard FHA 203(k) loan: This type can be used on major construction and structural renovations that cost at least $5,000. You’ll be required to work with an FHA-approved consultant, who will look at the house you want to buy and create an estimate for the work to be completed. The consultant will also check in during the repairs and sign off on them when they’re completed.
• Limited FHA 203(k) loan: Unlike the standard loan, the limited version caps the renovation portion of the loan amount at $35,000 and can only be used on minor repairs and remodels. Working with an FHA-approved consultant is also optional for this type of loan.

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

First-time homebuyers might be drawn to either an FHA 203(k) loan or an FHA 203(b) loan. Both have low requirements for down payment and credit scores, so they’re easier to qualify for. Here’s how the two programs compare:

203(k)-eligible home repairs

The government guides what repairs and upgrades you can spend your 203(k) home improvement funds 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) 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 where you’re home-shopping.

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,” Shekhar said. If you’re qualified, you could make some of the repairs yourself. 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, commercial or investment properties typically 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.