Buy and Rehab With the FHA's 203(k) Loan
You’re probably here because you’ve scoured the housing market and figured that a fixer-upper is your most affordable option.
You’re not alone.
In the past year, home prices have risen by about 20%—one of the highest year-over-year increases on record. As more and more people get priced out of the housing market, they’re purchasing distressed homes and upgrading them into livable spaces instead.
The median home sale price was $428,700 in the first quarter of 2022. (Source: St. Louis Fed)
Fortunately, the Federal Housing Administration (FHA) offers loan programs that can lend a helping hand. The FHA collaborates with lenders to provide loans that have more lenient qualification requirements. Instead of having to put 5%, 10%, or even 20% down, FHA-backed loans allow you to borrow up to 96.5% of the purchase price of a property—meaning you can become a homeowner for as little as 3.5% down. Better yet, FHA loans are suitable for borrowers with credit scores in the 500s, meaning that a low credit score won’t hinder your ability to buy a home.
The FHA offers a few different varieties of mortgages, such as the 203(k) loan. With this type of loan, you can remodel your kitchen, lay down new flooring, upgrade your windows, or buy a dishwasher. Don't get too excited, however—you can't use the loan to add a pool or build a gazebo!
What more can you do (or not do) with an FHA 203(k) loan? Let's find out!
What to know about the FHA’s 203(k) loans
An FHA 203(k) loan is a two-in-one government-insured mortgage that finances the acquisition of a home and its renovation. You can buy a distressed-but-affordably-priced property in a desirable neighborhood and rehabilitate or upgrade it to suit your preferences.
Want to buy a fixer-upper and give it some TLC? With an FHA 203(k) loan, you can!
However, lenders are often dubious about approving loans for homes that require major revamping. To motivate lenders to approve these riskier loans, the FHA promises to make the lender whole in the event a borrower defaults. As a result, borrowers have an easier time getting access to financing if they ever want to upgrade older properties or live in neglected areas. In turn, this makes both these homes and neighborhoods more habitable than before—leading to better outcomes for homeowners, communities, and cities at large.
Types of FHA 203(k) loans
The 203(k) loan comes in two flavors:
203(k) Streamline Loan. Also called a “limited” or “light” loan, the 203(k) streamline loan is appropriate for a property that needs just a few repairs. These repairs must amount to a maximum of $35,000. Notably, you can’t use a limited 203(k) loan if the repairs keep you out of the house for over 15 days.
Standard 203(k) Loan. These loans are suitable for properties that need extensive structural repairs of at least $5,000. There is no maximum amount, but the total value must fall within the FHA loan limits in your area. When using a standard 203(k) loan, it’s best that you engage a consultant certified by the HUD to manage the rehabilitation process.
Minimum qualifications for an FHA 203(k) loan
While FHA loans come with more lax underwriting standards—allowing a greater pool of borrowers to get approved for a loan—there are still a few requirements that you’ll need to meet if you want to obtain financing.
You’ll need to put at least 3.5% down and have a healthy DTI ratio to qualify for a 203(k) loan.
In particular, you’ll need:
A down payment of 3.5% (purchase price + repairs) with a 580+ credit score. For lower credit scores (500+), you’ll need to put 10% down. In contrast, some conventional rehab loans allow as little as 5% down, but with a credit score of 620+.
A debt-to-income (DTI) ratio below 43% is required. To calculate your DTI, divide your total monthly debt payments by your pre-tax monthly income.
The property should be your primary residence for at least 12 months (or one calendar year) following the purchase. You can't fix and flip using a 203(k) loan.
What projects can you do with an FHA 203(k) loan?
You can use a 203(k) loan to upgrade anything from a one-unit single-family home to a four-unit multi-family quadruplex. You can also buy and rehab an FHA-approved condo.
If you plan to renovate your home with a 203(k) loan, make sure you can finish the entire project within six months.
Renovation projects should begin within 30 days of closing. Engage a licensed contractor and ensure the repairs are completed within six months.
Here are examples of some repairs you can do with a 203(k) loan:
Roof repair and replacement
Installing new flooring
Kitchen remodeling and appliances
Bathroom remodeling
Electrical and plumbing systems repair
Driveway and sidewalk repair
Resolving any health and safety hazards, like lead-based paint, mold, or replacing broken windows and doors
Making energy conservation improvements
Demolishing the house and building a new one on the same foundation
Enhancing accessibility for people with disabilities
Keep in mind that this isn’t an exhaustive list of 203(k) eligible projects. You can pursue plenty of other upgrades and improvement projects with a 203(k) loan.
Projects that are ineligible for an FHA 203(k) loan
However, there are some projects that are expressly prohibited. For instance, you can't use a 203(k) loan to fund luxury or vanity renovations. Here are a few examples:
Adding a pool
Constructing a tennis court
Creating an outdoor fireplace or barbeque pit
Building a gazebo
Setting up a satellite dish
Are FHA 203(k) loans better than conventional loans?
FHA 203(k) loans have favorable interest rates, accept applicants with low credit scores, and feature lenient down payment requirements. With a single loan, borrowers can fund both home purchases and improvements. You can even use a 203(k) loan to pay for temporary housing during renovations.
If you have cash on hand, putting 20% down may be a good idea, since that’ll allow you to avoid MIP.
On the flip side, FHA 203(k) loans still require upfront and monthly mortgage insurance premiums (MIP), at least for borrowers who can’t afford to put at least 20% down. Also, you can't use them to acquire or rehab an investment property.
Meanwhile, conventional loans have strict application requirements, higher credit scores, and large down payments. However, they come with fewer restrictions, and permit luxury upgrades or renovation projects.
How do you get an FHA 203(k) loan?
You can borrow up to 110% of the property's post-renovation value as determined by an appraiser, or the purchase price plus the cost of repairs—whichever is less.
To apply for an FHA 203(k) loan, shop for an FHA-approved lender. You can find a list of these lenders using the HUD's approved lenders search. Get pre-approved, hunt for a house, get the home under contract, find a licensed contractor, collect bids from contractors, finalize your loan processing documents, close on the home, complete repairs, and move in.
Make sure you compare lenders and shop around. Collect bids so that you get the lowest rates!
203(k) vs. “standard” 203(b) loans
You now understand what a 203(k) loan is and what it can help you achieve. However, the FHA also has a standard loan, commonly known as the 203(b) loan. But what makes it different from the 203(k) loan?
Differences between 203(k) and 203(b) loans
The 203(b) mortgage is the standard FHA home loan for single-family homes. It’s the loan to use when purchasing a move-in-ready house. However, if you want to buy a property that needs significant repairs, a 203(k) will likely serve you better instead.
With a 203(b) loan, you receive the entire loan proceeds at closing. This isn’t the case with a 203(k) loan. Instead, lenders disburse the mortgage in bits. At closing, you receive funds for the home’s acquisition—that is, you receive proceeds equivalent to the purchase price of the home, less your down payment.
Afterwards, the lender deposits renovation funds in escrow. You’re provided with the first half to begin your repairs. The remaining half is paid after repairs are completed and the home is inspected.
If you buy a home using the 203(b) loan, it undergoes an appraisal to verify that it meets the FHA’s minimum property requirements. In case of minor repairs, they’re dealt with before closing the loan.
A 203(k) loan, on the other hand, needs a two-part appraisal—the first part shows the property’s current market value, and the second part shows its projected value once renovations are completed.
With a 203(k) loan, you may incur more for appraisal and origination fees since additional documents need to be drafted and reviewed for the rehabilitation process. Compared to the 203(b) loan, you’ll pay about a 1–2% higher annual interest rate.
You may not get the lowest rates with a 203(k) loan, but that doesn’t mean it’s not worth considering.
What are the similarities between a 203(b) and 203(k) loan?
That said, the FHA’s 203(k) and 203(b) mortgage programs share the same basic lending guidelines. Specifically, they both require:
A minimum credit score of 500+ with a 10% down payment, or a score of at least 580+ with 3.5% down
A debt to income ratio of less than 43%
The home must be your principal residence
The property should contain no more than four units
Is an FHA 203(k) loan right for you?
An FHA 203(k) loan is a fantastic option for several types of borrowers. For example, a 203(k) loan may be worth considering if you want to buy a run-down property and renovate it—but don't have the funds to make the necessary repairs and improvements.
You may also be a suitable candidate for a 203(k) loan if you want to refinance and fix a home you already live in that needs repairs of at least $5,000. Of course, an FHA loan can also serve you well if you simply want to get your foot in the door with a low down payment. From there, you can start building home equity as soon as possible.
That said, a 203(k) loan doesn’t come without its costs. To enjoy these benefits, you should be ready to:
Pay a higher interest rate, appraisal fee, and origination fee
Pay for upfront and monthly mortgage insurance premiums
Hire a licensed contractor approved by the HUD. (It’s important to keep in mind that only 10% of the work can be sweat equity—so unfortunately, you can’t take the DIY route to save on labor costs.)
Put up with a process that is longer and more complex than getting approved for a conventional, non-agency mortgage
In some instances, a simpler non-agency conventional loan may be your better bet.
Moreover, a 203(k) loan may not always be the best choice for borrowers. Occasionally, simpler alternatives exist. For instance:
A 203(b) loan with repair escrow will be the best option if your home needs minor repairs. It allows you to finance repairs up to $10,000
If the rehabilitation project is likely to take longer than six months, a 203(k) won't be a good fit
203(k) loans also aren’t suitable for you if you’re borrowing to rehab an investment property
A 203(k) loan may not be very useful if you want to make luxury or vanity improvements. In this case, you'd be better off with conventional non-agency debt. However, this kind of financing requires a higher credit score and down payment
Choosing a mortgage that works best for you
Before you settle down on any home loan, take some time to go through the options that can get your job done. Consider your financial situation. How much home can you afford? Check the qualification requirements.
Also, scrutinize mortgage origination fees, interest rates, and the loan terms. If your budget allows, it may also be wise to seek out an expert like a mortgage consultant, who will guide you through the borrowing process and help you explore all your options.
Conclusion
An FHA 203(k) loan wraps up the purchase of a property and its rehabilitation into a single loan. It’s a good option if you’re looking for affordable financing to upgrade your current home or want to buy a fixer-upper property. Depending on the cost of the renovations, you can choose a standard 203(k) or a limited 203(k).
However, if you want to buy a home that is ready to move in, go for an FHA 203(b) loan.
In general, FHA 203(b) and 203(k) loans have the same basic requirements. You need a minimum credit score of 580+ to put 3.5% down. Otherwise, with a 500+ credit score, you’ll need to put at least 10% down. Finally, the home you are looking to buy should be a residence with one to four units.
Choosing your mortgage loan option is an important financial decision. Research and shop for lenders upfront, and talk to experts to get the relevant information and guidance you need. Above all, make sure to take up a loan that best and most conveniently serves all your homeownership needs.
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