What Is an FHA 203(k) Loan & How Does It Work?
An FHA 203(k) loan is a government-backed mortgage that combines two loan types, for financing a property's purchase and funding the costs of the property’s renovations. Find out how it works to determine if you’re a candidate for this loan type.
Getting a mortgage can be difficult. Borrowers may end up with high interest rates or short repayment terms. And they may only be able to afford a property that requires extensive repairs. That is what FHA 203(k) loans aim to address. This type of loan combines a construction loan with a regular mortgage.
There are certain situations when it makes more sense for a potential homebuyer to take an FHA 203(k) loan. For instance, the homebuyer may want an older house with a lower purchase price. However, buying an old house can also mean significant construction needs. An FHA 203(k) loan can help with the renovation costs and finance the purchase price simultaneously.
Qualifications tend to be more lenient since the Federal Housing Administration (FHA) secures this loan type. That said, there are limitations to the amount and type of loan a homebuyer can take. Additionally, there are rules on what rehabilitation projects are eligible.
An FHA 203(k) loan is a government-backed mortgage that allows potential homebuyers to have a single loan to finance a home and fund renovation costs. This loan is a combination of a construction loan and a regular mortgage.
There are two types of FHA 203(k) loans: Standard and Streamlined. The Standard 203(k) loan is for major structural renovations, while the Streamlined 203(k) loan is for minor cosmetic repairs.
Potential homebuyers must meet the eligibility requirements to get an FHA 203(k) loan. These include restrictions on the type of property, loan amount and permitted rehabilitation projects.
What Is an FHA 203(k) Loan?
The 203(k) program was created to help homebuyers finance the purchase of a property and pay for the cost of rehabilitating the same home. The loan amount includes the cost of both the home purchase and renovation.
This program was first introduced in 2005 to provide a loan option for financing minor remodeling and non-structural repairs. For a project to be eligible, the repair amount should not exceed $35,000. Since 2005, changes have been adopted. For instance, loan limits vary depending on location and range. Now, the FHA lets borrowers access up to a 96.5% loan-to-value ratio.
Originally, an interested homebuyer would need separate financing to purchase and rehabilitate a home. These include a short-term purchase loan, a short-term loan and a long-term mortgage. The FHA 203(k) rehabilitation mortgage insurance program offers a simpler alternative. The FHA 203(k) loan has a more straightforward process.
Other than funding a home purchase, you can use an FHA 203(k) mortgage to refinance an existing mortgage. The proceeds of the loan can also be used for the rehabilitation of the borrower’s home.
An example of a situation in which taking out an FHA loan is a great option is when the property has suffered a federally declared natural disaster. In such a case, you may need to conduct repairs or renovations to your home. To fund the expenses, you can get an FHA loan.
How Does an FHA 203(k) Loan Work?
The eligibility requirements and qualifications for an FHA 203(k) loan tend to be more lenient than those for regular mortgages. That is because the FHA backs this loan type. The government guarantees and insures the loan, allowing lenders to take on more risk.
Depending on the borrower’s needs and circumstances, a loan can be taken as a 15-year or 30-year fixed-rate mortgage or as an adjustable-rate mortgage (ARM).
A down payment is necessary. Generally, you can have a down payment as low as 3.5%. That is why it can be the most affordable option for homebuyers with lower credit scores or those who can only pay a small down payment. Borrowers can opt for a higher down payment. Those who can afford at least a 10%–15% down payment and have good credit may find FHA loans more expensive than regular loans.
Amounts for this type of loan can’t exceed the limits set by the FHA. These may vary depending on geography and range. Limits tend to be lower in low-cost areas than in high-cost areas.
The pricing for an FHA 203(k) loan is based on the market conditions. Normally, the interest rate is 1% higher than a traditional FHA loan. Interest can either be fixed or variable. Borrowers can choose between a 15- and a 30-year term.
FHA 203(k) loan borrowers must pay both an upfront mortgage insurance premium and an annual mortgage insurance premium.
What Are the Types of FHA 203(k) Loans?
There are two types of FHA 203(k) loans: Standard 203(k) and Streamlined 203(k). Both types generally share the same dual loan purpose. However, they have different eligibility requirements, terms, loan amounts and permitted rehabilitation projects. It is important to understand both types and explore which of the two is best for your needs and situation.
Standard 203(k) Loans
Standard 203(k) loans are intended for extensive repair and substantial structural work. For instance, if you need to change your home’s roofing system, this type of FHA 203(k) is the better option. Other home renovations that can be considered extensive are room additions and plumbing replacement.
Before applying for an FHA 203(k) loan, make sure your property complies with local zoning requirements and minimum energy efficiency standards.
If you plan to apply for funding through a Standard 203(k) mortgage, covered uses include:
- A one- to four-unit property,
- The renovation of the residential portion of a mixed-use building, which is both retail/commercial space and residential,
- A conversion from a larger number of units to four or fewer units,
- The relocation of an existing house to a new foundation,
- Interior renovations on an FHA-approved condo, or
- Uninhabitable properties (as also called a "tear-down"), provided that a part of the existing foundation will remain
Property-related factors are only some of the requirements you need to meet to qualify for this loan type.
For home purchases, the maximum loan amount is determined by the lesser value of:
- The purchase price of the property before rehabilitation, plus the estimated cost of rehabilitation
- 110% of the projected market value of the property after the rehabilitation is complete
For refinances, the maximum loan amount is determined by the lesser value of:
- The estimate of "as-is value" before rehabilitation, plus the estimated cost of rehabilitation
- 110% of the projected market value of the property after rehabilitation is complete
The FHA loan process requires that an FHA-approved appraiser complete two appraisals of your property. The first appraisal estimates the property's market value in its current condition, or what is typically known as "as-is." The second appraisal estimates the property's market value based on the assumption that the rehabilitation has been completed.
The scope of rehabilitation permitted when financing with a 203(k) mortgage varies. Although renovation costs must exceed $5,000, the reality is that planned renovations can range from relatively minor work to virtually a complete reconstruction of a home that has been demolished, providing the existing foundation remains.
Determine if your planned renovations include at least one of the following types of construction:
- Structural alterations and reconstruction, including additions to the structure, finished attics, repair of termite damage or treatment against termite infestation
- Changes for improved function and modernization, like remodeled kitchens or bathrooms
- Elimination of health and safety hazards, including defective paint surfaces or lead-based paint in homes built before 1978
- Changes for aesthetic appeal, such as new exterior siding and other elimination of obsolescence
- Reconditioning or replacement of plumbing, including connecting to public water and sewer systems, HVAC and electrical systems
- Exterior weather and water, including roofing, gutters and downspouts
- Flooring, tiling and carpeting
- Energy conservation improvements, including new double-pane windows, insulation, solar domestic hot water systems
- Major landscape work and site improvement that includes patios and terraces that improve the value of the property or preserve the property from erosion
- Improvements for handicap accessibility
Streamlined 203(k) Loans
Streamlined 203(k) loans are also referred to as Limited or Simplified 203(k). This type of loan is best for simple cosmetic repairs or minor renovations. For example, homeowners who need new flooring, gutter repair or minor room remodeling will benefit from this loan.
Streamlined 203(k) guidelines allow financing for FHA-approved condominiums, townhouses, mixed use, storefront properties and one- to four-unit properties.
- For Purchases
The purchase price of the property before rehabilitation, plus the estimated cost of rehabilitation, or 110% of the projected market value of the property after rehabilitation is complete.
- **For Refinances
The estimate of "as-is” value before rehabilitation, plus the estimated cost of rehabilitation, or 110% of the projected market value of the property after rehabilitation is complete
FHA 203(k) mortgage guidelines require that an FHA-approved appraiser complete two appraisals. The first appraisal estimates the property's market value in its current condition, or its "as-is" value. The second appraisal estimates the property's market value assuming the rehabilitation has been completed.
The Streamlined 203(k) loan is designed for homebuyers who need less extensive home improvement projects. It is a practical option for homeowners looking for ways to make minor home repairs without exhausting their savings to accomplish their goals. Furthermore, a Streamlined 203(k) does not require a minimum repair cost.
One example of a minor improvement project that may be covered by Streamlined 203(k) is a change in flooring. You can also use this loan to improve your home's energy efficiency. For instance, you can apply for a loan to upgrade your home’s insulation.
The application and approval process for a Streamlined 203(k) mortgage is simplified by limiting the loan amount to $35,000 and the type or extent of allowed renovations. If you are thinking of doing renovations that require drawings, consultants, engineers and/or architects, consider hiring a 203(k) consultant and getting a Standard 203(k) mortgage.
Generally, planned repairs being financed with a Streamlined 203(k) loan should take between 1.5 to 3 months to complete. When rehabilitation is finished, a HUD-approved inspector performs a final inspection to ensure the work was finished as planned.
A Streamlined 203 (k) loan permits the following discretionary improvements:
- Repair or replace roofs, gutters and downspouts
- Repair, replace or upgrade existing HVAC systems
- Repair, replace or upgrade plumbing and electrical systems
- Repair or replace flooring
- Minor remodeling projects that do not involve structural repairs
- Exterior and interior painting
- Weatherizing of storm windows and doors, including insulation and weather stripping
- Purchase major appliances like ranges, refrigerators, washer/dryers, dishwashers and microwave ovens
- Accessibility improvements for persons with disabilities
- Stabilization or abatement of lead-based paint hazards
- Repair, replace or add exterior decks, patios and porches
- Basement remodeling projects that do not involve structural repairs, including waterproofing
- Window and door replacements, including exterior wall re-siding
- Repair or replace the septic system or well
FHA 203(k) Loan Requirements
Given that 203(k) is a subtype of the FHA loan, it’s naturally easier to qualify for a loan. The eligibility requirements are flexible. They are similar to the qualifications necessary for a standard FHA loan. That said, potential homebuyers and homeowners who apply must meet the minimum requirements.
Before proceeding with the application, it is important to know the qualification requirements. This will help you ensure that you are eligible for a 203(k) loan.
For an FHA 203(k) loan, lenders typically require a credit score of at least 500–580. However, some lenders may require a credit score of around 620–640. This range is still lower than the requirement for a regular mortgage which requires at least a 720 score.
Debt-to-Income Ratio (DTI)
Generally, the front-end debt-to-income (DTI) ratio should not be more than 31%. Back-end DTI, on the other hand, should not exceed 43%.
That said, lenders may have different policies. You may find a lender that accepts higher DTI, especially if you have a higher credit score.
Minimum Down Payment
Down payment for an FHA 203(k) loan can be as low as 3.5%. However, this is usually only possible for candidates with a minimum credit score of 580. Homebuyers with lower credit scores (500–579) typically must put down 10%.
Loan Amounts and Occupancy
The candidate can only use the FHA 203(k) loan on their primary residence. It’s also important to take note of the FHA loan limits in your region. Loan limits tend to be lower in low-cost areas than in high-cost counties.
Applying for a 203(k) Mortgage
Interested borrowers must go through the application process. Lenders follow clearly defined steps that candidates must complete. Familiarizing yourself with the process can help you know what to expect. Below is a simple guide to help you get started.
203(k) Pre-Approval Process
The most sensible approach to any mortgage undertaking is to begin by selecting an FHA-approved lender to analyze your financial situation before finding your dream home. Get a pre-approval letter before you even begin looking for a property.
- Pre-Approval Letter
Don’t skip the pre-approval step. It is now standard practice in real estate for purchase offers to include a pre-approval letter. Most offers are not even considered bona fide if they lack a pre-approval letter.
- Learn Your Options
During the initial phase of the mortgage loan process, you will begin to gather your financial and legal information for submission to an FHA lender. You can give yourself a head start by investigating your financing options upfront. Perhaps the most significant benefit is allowing yourself to learn about your mortgage options.
With your pre-approval in hand, you can begin searching for that perfect property, which must also meet FHA’s 203(k) guidelines.
- Repair Wish List
With a specific property in mind, create a wish list of property repairs. Create a list of must-haves and nice-to-have repairs. Must-haves address the property's structure and the health and safety of your family. Nice-to-haves are not crucial to your occupancy of the house, but would improve its value and comfort.
- FHA 203(k) Consultant
Depending on the cost and extent of repairs, you may need to hire an FHA consultant to act as a coach and referee who decides which repairs are must-haves or nice-to-haves, and to authorize payments to your contractors. (More on FHA Consultants later.)
203(k) Offer Preparation
Complete the FHA mortgage application after your lender gives you approval to move ahead with the loan process. This usually requires you to pay an application fee.
- Complete 203(k) Forms
A 203(k) mortgage requires the use of particular 203(k) forms. If you hire an FHA consultant, they will complete a Maximum Mortgage Worksheet to help keep your financing goals reachable and within guidelines.
- Make a Realistic Offer
The next step is organizing and preparing your offer. Stay realistic about the property’s required repairs and its post-repair appraised value. Unrealistic estimates will complicate matters during construction and may even leave you short of funds. You are now ready to present your offer to the seller.
203(k) Offer Acceptance
When the seller accepts your offer, set up a meeting with your contractor and FHA consultant to prioritize the property’s repairs as either must-dos or nice-to-haves. When you have a solid understanding of what repairs are required to meet FHA’s minimum standards, you can meet with your FHA lender to discuss the particulars regarding the anticipated costs to repair the property.
In your mortgage application, include a comprehensive proposal detailing the scope of renovation work. This is critical, and where you will find the FHA consultant helpful. This comprehensive proposal should describe both cost and time estimates for each improvement.
- Appraisals & Inspections
As a part of the application process, your lender will order an FHA appraisal, survey, and inspections for pest, septic and well water. This is also when the lender’s processing department will issue a credit approval based upon the income, assets and credit history information you submitted.
- Maximum Loan Amount
The lender will calculate the maximum loan amount for your transaction based upon a value determined by your recent appraisal. Once approved, the lender will finish its paperwork and schedule a closing date shortly after.
Once the closing date is set, it is crucial to advise your contractor of this date as soon as possible because this gives the contractor the time to coordinate the many facets involved in construction.
If you have never been involved in a mortgage closing, you might be surprised at what seems like an endless pile of paperwork you must sign and initial at closing.
- Where the Money Goes
When the paperwork is complete, the funds will be disbursed to pay either the seller or to pay off your current mortgage. The remaining funds from the FHA 203(k) mortgage will be placed in an interest-bearing escrow account managed by the lender during the construction phase.
- Call Your Contractor
The moment you close your 203(k) loan, call your contractor and ask them to pull the necessary building permits so the repairs and rehabilitation can begin. The planned construction must begin within 30 days of your loan closing.
Send copies of your building permits to your lender. This lets the lender knows you are moving forward as promised.
- Funds Disbursement
The lender will begin to disburse funds from the escrow account as the planned construction is completed.
- FHA Inspection
When all work is complete, the lender will order a final inspection by an FHA-approved appraiser.
Closing of the Escrow Account
When the FHA inspector issues a final inspection report, the lender will disburse the final escrow payment.
- Behind the Scenes
Expect the lender to order a title update to ensure the title to your property remains clear. The lender closes the escrow account and the 203(k) mortgage becomes a standard FHA loan.
- Final Disbursement
The final release of the escrowed rehabilitation funds will occur after the local jurisdiction, such as the county building inspector, provides its final acceptance of the work.
Pros & Cons of an FHA 203(k) Loan
While a 203(k) loan can help you achieve ownership of your dream home, it is important to remember that it is still a loan that you will need to pay back. Make sure you weigh the benefits and drawbacks to determine if you’re fit to take this commitment.
Advantages of an FHA 203(k) Loan
For some homebuyers, an FHA 203(k) loan is the best option. Here are some of the advantages that make this type of loan appealing to many borrowers:
- Low credit score requirements
- Low down payment requirements
- Competitive interest rates
- Combines the purchase and renovation of a home into one loan
- Able to provide temporary housing while the home is under renovation
Disadvantages of an FHA 203(k) Loan
Despite the advantages, FHA 203(k) loans also have drawbacks. Here are some of the reasons why a borrower may decide not to get a 203(k) mortgage:
- Must pay mortgage insurance premium (MIP) upfront
- Can’t be used for investment properties
- Monthly MIP is required
- Certain projects may require a HUD consultant
- Long application process
Frequently Asked Questions About FHA 203(k) Loans
Ray Roeske is a renovation and construction sales manager at George Mason Mortgage LLC. Roeske offered the following guidance to borrowers who are considering an FHA 203(k) mortgage.
How do the costs compare between FHA 203(k) mortgages and the more traditional loans?
For these types of loans, both mortgages require mortgage insurance to be paid by the borrower. Although these mortgage insurance premiums can vary from year to year, the current cost of mortgage insurance between both loans is relatively similar. But, FHA 203(k) mortgages are currently available with a slightly lower interest rate.
How important is the FHA consultant in closing a 203(k) loan?
Remember that you really don’t have a choice about hiring a 203(k) consultant if you plan to apply for the full or Standard 203(k) mortgage. The application process requires that you hire one. Hire an FHA-approved consultant for either 203(k) mortgage to help guide you through the process. It is simply a prudent business practice.
What should a borrower look for when seeking a 203(k) consultant?
Hiring an FHA Consultant who is knowledgeable in both the lending side of the program and also in the construction side of the program is your best bet. The lender and the consultant must work together for the transaction to go smoothly and according to plan.
Any other advice you would offer for homeowners planning to apply?
Be imaginative when envisioning planned renovations, but do your homework too so you don’t overlook the essentials For example, ask how old the roof is — it might look okay, but actually be nearing the end of its 25-year projected life. Remember the must-haves when you tackle a rehabilitation.
About the Author
- HUD Exchange. "New FEMA Major and Emergency Disaster Declarations." Accessed June 3, 2022.