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Buying a fixer-upper home instead of a turnkey property can help you save money — as long as you have the time and budget to complete the necessary repairs. However, depending on the property condition, you might struggle to qualify for a traditional home loan.
Thankfully, you can apply for an FHA 203(k) loan. This type of mortgage rehabilitation loan is easier to qualify for than a conventional home loan and can potentially help you transform your distressed property into one of the best lots in the neighborhood.
Here’s what you need to know about FHA 203(k) loans:
- What is a 203(k) loan?
- How does a 203(k) loan work?
- 203(k) loan types
- 203(k) loan uses
- 203(k) loan requirements
- 203(k) loan process
- 203(k) loan pros and cons
What is a 203(k) loan?
There are several FHA home loan programs available to you. Most single-family homes requiring minimal repairs are eligible for 203(b) loans — the most common FHA loan.
But when a house needs extensive work for health, safety, and/or security reasons, you may need to apply for a 203(k) mortgage instead. Also known as a Section 203(k) loan, this rehab loan lets you buy the property as-is and use funds from the loan to complete the necessary repairs. You can also refinance your existing mortgage to perform structural and cosmetic repairs to your current home.
While Credible doesn’t offer 203(k) loans, our streamlined process makes comparing rates for conventional loans easy. It only takes a few minutes to see prequalified rates and generate a streamlined pre-approval letter using our free online tools.
How does a 203(k) loan work?
You can purchase or refinance a home that’s at least a year old with an FHA 203(k) rehab loan. Primary residences requiring structural repairs and minor improvements are eligible for financing with a fixed or adjustable interest rate.
A Section 203(k) loan can be an excellent option as you only need to apply for one loan to secure the property and finance repairs with lenient borrower requirements.
While 203(k) loan requirements are typically more lenient than other home loans, the application process can be more tedious. For example, the lender requires a list of specific repairs, a cost estimate, and hiring a licensed contractor before you can close and make an initial draw.
Good to know: Only repairs or renovations that add value to the property will qualify. Certain luxury items like swimming pools and barbecue pits aren’t allowed. And while you may not have to occupy the home immediately, you’ll only have six months to complete the proposed projects.
203(k) loan types
There are two different 203(k) renovation loan options. Your estimated repair costs and the types of repairs determine which loan to apply for.
Limited 203(k) loan
A limited 203(k) loan — formerly known as a streamline 203(k) — allows you to borrow up to $35,000 for repairs or improvements. These loans are often better suited for cosmetic or non-structural repairs like a kitchen remodel or new flooring. Essentially, you’re performing the repairs that the seller didn’t do, allowing you to buy the house at a potential discount.
Here are some of the features of this loan type:
- Cosmetic repairs only: Most minor remodels and non-structural repairs are eligible but an approved contractor must finish the work within six months.
- Contingency reserve: While you can borrow up to $35,000 for repairs, the lender may require a 20% contingency reserve — essentially, funds that are set aside to cover any cost overruns. For example, you might borrow $35,000 for repairs but the lender might withhold up to 20% (in this case, $7,000) in a reserve. They’re recommended, but not required, for limited 203(k) loans.
- Homebuyers and homeowners can apply: This loan is available to buyers and existing homeowners. However, you cannot refinance an active 203(k) loan.
- Self-made work plan: You may not have to work with a 203(k) consultant to draft a work plan for any repairs and improvements. However, your mortgage lender must approve the plan and the contractors you hire.
Standard 203(k) loan
If your home requires major structural repairs to get it into live-in condition, the standard 203(k) loan is a better option. This loan can also be a great alternative to construction loans when you retain the original foundation but need to rebuild or modify the existing structure.
The main features of this loan include:
- Minimum $5,000 in improvements: You’ll only need to complete at least $5,000 in eligible improvements to qualify for a standard 203(k) loan.
- Contingency reserve: Lenders require a contingency reserve of up to 20% of the amount you borrow on all standard 203(k) loans.
- Complete major repairs: You can use this loan for significant repairs or remodeling as long as the original foundation exists. For example, you could rebuild the original structure or convert a single-family home into a multi-family property.
- Work with a 203(k) consultant: An FHA-approved 203(k) consultant must create your work plan and cost estimates. Qualified borrowers that perform their own work may be able to waive this requirement but cannot receive payment for the labor.
- More eligible repairs and improvements: Some repairs and improvements that aren’t eligible for funding with a limited 203(k) loan are eligible with a standard 203(k) loan. These include landscaping, structural rehabilitation, and installing storm shelter additions.
203(k) loan uses
You can use a 203(k) loan for many non-luxury repairs and improvements. Here are some ways to boost the value of your property using either 203(k) loan:
- Heat and air conditioning systems
- Well or septic system
- Energy conservation improvements
- Smoke detectors
- Exterior decks, patios, and porches
- Walkways and driveways
203(k) loan requirements
Here are some of the FHA requirements you’ll need to meet:
- Credit score: You’ll need a credit score of at least 500 to apply. However, 203(k) loan lenders may require a score above 600.
- Down payment: Your down payment is 10% with a credit score between 500 and 579. But you’ll only need to make a 3.5% down payment with a score of 580 or higher.
- Mortgage insurance premiums: You’ll pay an upfront mortgage insurance premium of 1.75% on the purchase price and repair funds. This loan also has an annual premium for the life of the loan. You can cancel the premium after 11 years if your initial down payment is 10% or higher.
- Employment history: You may need to provide proof of employment for the last two years. Your two most recent tax returns may also qualify. Traditional W-2 or self-employment income can qualify with a consistent work history.
- Debt-to-income ratio (DTI): Your maximum debt-to-income ratio is 43% in most instances. The DTI can be as high as 50% when you have qualifying income and cash reserves.
- Loan limits: You can borrow up to the nationwide mortgage limit or 110% of the estimated property value after improvements, whichever is less. In 2021, the mortgage limit is $356,362 in most counties for a single-family home and $822,375 in higher-cost areas.
- Primary residences only: 203(k) loans are only for primary residences. You must intend to live in the house for at least one year after the closing date.
- Must be an existing property: Your home must be at least a year old. The home can be a single-family home with one to four units, a condominium, or a manufactured house if the original foundation remains undisturbed.
- Closing costs: You’ll have to pay several fees including origination, appraisal, 203(k) consultant, and contractor charges.
203(k) loan process
Here is a look at how to apply for a 203(k) loan:
- Apply with a 203(k) lender: Compare pre-approval rates from several mortgage lenders offering 203(k) loans. The lender can help you determine if a standard or limited 203(k) loan is better.
- Gather your documents: After identifying a property, apply for financing by submitting your personal, employment, and property details.
- Home appraisal: Your lender may require an initial inspection to determine the current property value and amount you may borrow for repairs. A 203(k) consultant can identify the necessary work items and total cost estimate.
- Hire a contractor: Unless you’re a professional contractor, you’ll need to hire a licensed general or specialized contractor before the loan closing date to complete the repairs. Using a contractor with previous 203(k) experience can prevent delays.
- Close on the loan: After hiring a qualified contractor, you can close on the loan to purchase the property and draw the initial repair funds. You’ll need to pay the closing costs, down payment, and upfront mortgage insurance premium.
- Complete the repairs: You have six months to complete the necessary repairs with a 203(k) loan. The work must start within 30 days of the closing date and the lender requires routine progress updates.
- Borrower’s letter of completion: You’ll provide the lender with a signed letter of completion stating all necessary repairs are complete to your satisfaction. Any unused funds from your contingency reserve will be applied to your loan principal.
- Occupy the house: You might be unable to occupy the dwelling until the necessary repairs are complete. After gaining a certificate of occupancy, you can move into your home to finalize the loan process.
203(k) loan pros and cons
These are the advantages and disadvantages of an FHA 203(k) rehab loan:
- Most repairs qualify: Many minor and major repairs and improvements are eligible and can increase your property value quickly.
- Flexible borrower requirements: This loan type typically requires a lower credit score and down payment than conventional mortgages and construction loans. You can also apply for a 203(k) purchase or 203(k) refinance loan.
- Flexible borrowing limits: You can borrow up to your area’s borrowing limit or 110% of the after-repair property value.
- Lenient property requirements: While you must make repairs, 203(k) loans accept properties that may not pass the appraisal process for a conventional mortgage. Buying a fixer-upper at a low price can give you a tidy sum to spend on repairs and may end up being cheaper than purchasing a turnkey property.
- Short repair window: You only have six months to complete the required repairs. Lenders may grant an extension for extreme circumstances. Houses with excessive damage may not qualify despite selling at a bargain price.
- Must hire a contractor: You’ll need to use a professional contractor to complete the work. Standard 203(k) loans also require hiring a consultant during the application process to develop a work plan. This oversight can complicate the purchase process.
- No investment properties: This program is strictly for primary residences that you plan on living in for at least one year. Rental homes and fix-and-flips don’t qualify.
- Mortgage insurance premiums: Like other FHA loans, you’ll have to pay mortgage insurance, possibly for the life of the loan. A 1.75% upfront mortgage insurance premium (UFMIP) is due at closing and an annual mortgage insurance premium (MIP) not exceeding 0.85% also applies.