FHA 203(k) Loan Guide: Renovation Loan Requirements

FHA loans typically do not allow buyers to purchase homes that require renovations. Fortunately, the FHA 203K loan program offers one such option. With this program, buyers can purchase a home and pay for limited repairs, all with a single loan.

Below, we break down how the FHA 203(k) loan works, what’s required to qualify, which renovations are allowed, and the key limitations to keep in mind so you can decide whether this option makes sense for your homebuying plans.

About the FHA 203(k) Loan

With most traditional mortgage loans, lenders will not pay for home renovations in addition to a purchase. Instead, buyers need to buy the home, then A) pay cash for repairs, or B) take out an additional loan. This situation poses a challenge for buyers who want to buy a home and complete some repairs. Fortunately, the FHA offers an alternative financing option for fixer-uppers.

With the FHA 203(k) loan, buyers can finance two items with the same loan:

• The home purchase, and
• Needed/desired repairs

Furthermore, most lenders won’t approve loans for homes that require major repairs – let alone actually finance those repairs. Accordingly, the FHA 203(k) solves two major problems. First, it lets buyers purchase homes that wouldn’t otherwise qualify for a mortgage. Second, it lets these same buyers finance those repairs with the same acquisition loan.

NOTE: The FHA still requires that these homes meet baseline safety and habitability standards. If the property is too distressed, it will not qualify for an FHA 203(k) loan.

FHA 203(k) Loan Requirements

FHA 203(k) loans fall under the FHA loan program. This system means that borrowers must meet certain FHA-mandated criteria to qualify for the loan:

• Credit Score: For standard FHA loans, borrowers need a credit score of at least 580. However, some lenders may boost this to 620-640 for a 203(k) loan. While higher, this score range is still far better than the 720 or so required for conventional construction loans.
• Debt-to-Income: This ratio, abbreviated as DTI, equals your total monthly debt payments (including your future mortgage) divided by your total gross (pre-tax) monthly income. Most lenders will require a DTI of 43% or lower for an FHA 203(k) loan.
• Minimum Down Payment: As with all FHA loans, borrowers must provide a minimum down payment of 3.5%. But, with 203(k) loans, lenders base this percentage on the purchase price plus project cost. For example, say you want to purchase a $250,000 home and complete $30,000 in repairs. Your required down payment would be $9,800 ($250,000 plus $30,000 = $280,000, multiplied by 3.5% = $9,800).

NOTE: As with standard FHA loans, borrowers can receive 100% of their down payment as a gift from a family member or a qualified nonprofit organization.

• Loan Amount: Borrowers can qualify for up to the lesser of: A) 110% of the proposed future value of the home; or B) the purchase price plus rehab costs. But, regardless of these numbers, the loan total cannot exceed the FHA loan limits in your area.
• Occupancy: FHA loans exist to foster homeownership. To use the 203(k) loan, you must occupy the home as your primary residence. As such, investors cannot use this loan to fix and flip properties.
• Citizenship: Only US citizens and lawful permanent residents can use FHA 203(k) loans (and all FHA loans). Your lender will confirm your citizenship status during the application process.

Guide to Using the FHA 203(k) Loan

For the most part, buying a home with an FHA 203(k) loan is similar to buying a home with any other loan. Some key differences exist, though:

Step 1: Find an Eligible Lender

Not all lenders have FHA approval. Of the approved ones, not all will provide FHA 203(k) loans. Accordingly, borrowers must first find an eligible lender that provides this type of loan. Fortunately, the lenders that do provide 203(k) loans tend to have significant experience with them, meaning they can help you along the way.

Step 2: Apply and Receive Loan Pre-Approval

After you find a lender, you should apply for loan pre-approval. When buying a home, you should always take this step before looking at properties. First, pre-approval makes you a more competitive buyer, as many sellers won’t consider offers from buyers without a pre-approval letter. Second, it helps you avoid the heartache of falling in love with a home that is too expensive.

Step 3: Find a Property and Make an Offer

Armed with a pre-approval letter, you can work with a real estate agent to find properties. You’ll want to find “sweet spot” properties. On the one hand, they should require enough repairs to justify a discounted purchase price. On the other hand, they do not need too many repairs to qualify for an FHA 203(k) loan. Working with an agent familiar with this loan product will help you narrow down available homes.

Once you find a home, you need to make an offer. As with any home purchase, this process will likely involve some back-and-forth negotiations. Regardless of the contract price, ensure the purchase agreement includes language stating that you will use an FHA 203 (k) loan.

Step 4: Find a Contractor and Get A Bid

Once under contract, you must find a general contractor to provide a detailed renovation bid. (NOTE: Unless you work as a full-time, professional contractor, lenders will not allow you to personally complete the renovation work.) This bid will include a detailed description of all rehab work to be completed and the associated costs. The FHA also requires contractors to complete certain loan-specific forms, so it helps to work with a contractor who is familiar with them.

Lenders will require you to complete any safety or health hazard renovations first (e.g., mold, lead-based paint, damaged windows, etc.). After completing those items, you can focus on the cosmetic repairs you’d like to make (e.g., new appliances, granite countertops, updated bathrooms). After you and your contractor work together to develop this bid, you’ll submit it to your lender for review.

Step 5: Lender Orders Appraisals

Once the lender approves your proposed renovations and the associated contractor bid, they will order two appraisals. One appraisal will confirm the property’s “as-is” value, that is, what it’s worth before the renovations. The second appraisal will incorporate the proposed contractor bid and comparable properties to determine an after-rehab value, that is, what the property will be worth.

Buyers need these two appraisals due to the aforementioned FHA 203(k) loan ceilings. As stated, lenders will issue the lower of A) 110% of the proposed future value of the home, or B) the purchase price plus rehab costs.

Step 6: Close the Loan and Begin Work

Following these appraisals, the banks will approve the final loan amount. If the appraisals come in lower than the purchase price, buyers have one of three options: 1) pay the difference in cash, 2) negotiate a lower purchase price with the seller, or 3) walk away from the deal.

Assuming the appraisals come in above the contract price, you will then close on the loan. With an FHA 203(k) loan, the seller will be paid immediately upon loan closing and disbursement of funds. The lender will place the remaining balance into an escrow account. Similar to a construction loan, the lender will release escrowed funds directly to the contractor as the work is completed. Once the contractor finishes and has been paid for everything owed, you’ve completed the FHA 203(k) loan process.

What Renovations Can You Do with the FHA 203(k) Loan?

FHA 203(k) loans provide you with a tremendous amount of flexibility in terms of what renovations you can complete. While not an all-inclusive list, here are some of the major items allowed with these loans:

• Structural changes
• Updating a single-family home into a duplex, triplex, or quadplex
• Converting one of the above “plexes” into a single-family home
• Connecting to public utilities (sewer or water)
• Large landscaping projects (with some restrictions)
• Accessibility upgrades for disabled persons
• Relocating the home to another site

What Renovations Can You Not Do with the FHA 203(k) Loan?

Despite the above flexibility, the FHA does impose some restrictions on 203(k) loans. In particular, borrowers cannot:

• Complete minor landscaping projects
• Add luxury amenities like swimming pools, BBQ areas, or tennis/basketball courts
• Complete projects that will require longer than nine months for the Limited 203(k) program and twelve months for the Standard 203(k) program

Additional FHA 203(k) Loan Considerations

Interest Rates

Borrowers should expect 203(k) interest rates to be approximately 0.75% to 1% higher than standard FHA loan rates. Fortunately, FHA loans typically offer extremely competitive rates, which slightly offset this premium.

Mortgage Insurance

As with all FHA loans, 203(k) loans require mortgage insurance. This insurance includes two parts. First, buyers must pay a lump-sum fee of 1.75% of the loan amount, which is typically rolled into the loan. Second, you must pay 0.85% annually, which lenders generally divide by 12 and add to your monthly mortgage payments.

Time & Paperwork

FHA 203(k) loans also typically take longer to close than a standard loan, generally 60 days rather than 30 to 45. This increased time is largely due to the significant paperwork burden. On average, 203(k) loans require twice to three times as much paperwork as a standard FHA loan. Recognizing this reality, set clear expectations with the seller. It’s better to plan for 60 days from the beginning than to set an unrealistic closing date and need to change it.

Final Thoughts

For primary homebuyers looking for fixer-uppers, the FHA 203(k) loan can be a great option. It lets you finance a purchase and rehab with a single loan. In most other situations, buyers would need to either apply for a traditional mortgage and A) pay cash for the rehab, or B) apply for a second loan to finance this work.