What is an FHA 203(k) Loan and How Does it Work?

IN THIS GUIDE

Backed by the Federal Housing Administration (FHA), a 203(k) loan allows borrowers to fund the purchase and/or renovation of their primary residence. One of the key advantages of an FHA 203(k) loan is that it is easier to qualify for than a rehab or construction loan from a traditional lender. If you’re interested in an FHA 203(k) rehab loan, here’s what you need to know. 

What Is an FHA 203(k) Loan?

The FHA 203(k) loan can be used in two ways:

  • To renovate your existing home.
  • To purchase a residence and improve it.

 

In either case, the property will need to be the borrower’s primary residence for them to qualify for the FHA 203(k) loan program.

How Does an FHA 203(k) Loan Work?

For borrowers seeking to purchase a home, a key feature of the FHA 203(k) loan program is that it combines the purchase of the property and its renovation costs into a single mortgage. This allows for the borrower to immediately invest in renovations, but pay for them over time as they pay down their mortgage. 

Meanwhile, homeowners who are interested in an FHA 203(k) rehab loan to cover the cost of renovations will be able to refinance their existing mortgage and roll in the costs of renovation so they end up with a single monthly payment. As part of that payment, you’ll also have to cover the cost of mandatory FHA mortgage insurance

Types of FHA 203(k) Loans

The two types of FHA 203(k) loans include the “streamline” or “limited” loan and the standard or “consultant” loan. The type of FHA 203(k) loan you choose will impact how much you can spend on renovations.

  • The limited loan grants borrowers up to $35,000 for renovations. However, the limited loan does not allow you to use this money to repair major structural issues. 
  • The standard loan grants borrowers $5,000 or more for renovations. Unlike the limited loan, these funds can be used to repair structural issues. However, you’ll need to work with a HUD consultant during the renovation process.

 

Whether you intend to purchase a home or refinance your existing home, both of these loan types are available to you. 

What Can an FHA 203(k) Loan Be Used For? 

There are certain restrictions with both the limited and standard FHA 203(k) loans that will impact how the funds can be spent. Some of the most common investments made using the FHA 203(k) loan program include: 

  • Improving the functionality or visual appeal of your home.
  • Eliminating hazardous materials and damages.
  • Improving the water pipes and sewage system.
  • Replacing or repairing the roof and gutters.
  • Replacing or repairing flooring throughout the home.
  • Making significant improvements to the landscape.
  • Creating accessibility for a resident with disabilities.
  • Increasing the energy efficiency of the home.  

 

This list does not represent all of the projects that qualify for the program, but it helps to demonstrate the versatile ways in which borrowers can spend their renovation budget.  

FHA 203(k) Loan Qualifications

Like other loan programs available from the FHA, borrowers may be eligible for the 203(k) loan program even if they do not qualify for a conventional loan. The requirements for an FHA 203(k) loan include the following:

  • A minimum credit score of 500 points, although some lenders may require a higher score. The higher your credit score, the lower your interest rate.
  • A down payment of at least 3.5% if you have a credit score of at least 580. If you have a lower credit score, you will have to put 10% down. 
  • A clean credit history. If you have a recent bankruptcy or a foreclosure within the last three years, you may not be eligible. 

 

It’s important to note that FHA loans do have a borrowing limit. This limit slightly increases each year but is currently $420,860 in lower-cost counties and up to $970,000 in more expensive counties. You can find information on the borrowing limit in your county on the HUD website.

Remember that your credit score and income will determine how much you are eligible to borrow, so you may not receive 100% of the borrowing limit. If you want to increase your borrowing power, you will need to reduce your monthly debts, increase your income, or put more money down at the time of purchase. 

Conventional Loans vs. FHA 203(k) Loans 

It’s always a smart idea to compare your loan options before taking out a mortgage. The FHA 203(k) loan is favored for having more lenient eligibility requirements and a low down payment requirement. However, borrowers with a good amount in savings and a high credit score will find it easy to qualify for conventional construction and rehab loans. 

RequirementsFHA 203(k) LoanConventional Loan
Down payment3.5% to 10%20% or more
Credit score500 to 580 minimumTypically 620
IntentionPrimary residence onlyPrimary, secondary, investment
ConsultancyHUD consultant for standard loanNo consultant required
RenovationsOnly certain projects eligibleNo restrictions on renovations
Borrowing limit$420k to $970kNo preset limit

As you can see, conventional loans offer greater flexibility, but they can be more difficult to qualify for, and they require more money down. If you qualify for conventional loans, it’s worth comparing your options side-by-side. Additionally, if you’re seeking a loan to purchase an investment property, you should also consider fix-and-flip loans.

Pros and Cons of FHA 203(k) Loans 

Borrowers interested in taking out an FHA 203(k) loan are often attracted to this program for its lenient eligibility requirements and its low down payment requirements. However, there are other benefits and drawbacks to consider.

Pros of an FHA 203(k) Loan

  • Down payment as low as 3.5%.
  • Qualify with a credit score as low as 500.
  • Lower interest rate than credit cards and private money loans.
  • Can cover the mortgage payments for an uninhabitable property during renovations.

Cons of an FHA 203(k) Loan

  • Restricts how you can use the money.
  • Requires FHA mortgage insurance.
  • Home must be your primary residence.
  • May require you to work with a HUD consultant.

How Do I Start the FHA 203(k) Loan Process?

If you decide that the FHA 203(k) loan program fits your needs, the first step is checking your eligibility. Start by finding an FHA-approved lender in your area. Most allow you to begin the application process online, which requires you to disclose your Social Security number (SSN) and provide information about your income and debts. 

Using your SSN, the lender will request a credit report to review your credit history and check your score. If you pass the preliminary requirements, such as fitting within the lender’s debt-to-income ratio, you will be shown an interest rate and loan amount. To get the best rate, collect a few of these pre-qualifications before choosing a lender. 

Conclusion

The FHA 203(k) loan program is an excellent solution for borrowers who would like to purchase or refinance their primary residence and roll the cost of renovations into their monthly mortgage payment. However, while the FHA loan program provides a lower minimum down payment and more lenient eligibility requirements, it also poses restrictions.

For borrowers who qualify for conventional loans and have the savings to put more money down up-front, a conventional loan may offer the flexibility they’re looking for. Additionally, conventional loans empower borrowers to invest in a secondary home or investment property, whereas the FHA program is limited to your primary residence.

All in all, the FHA program is worth considering for any borrower seeking a rehab loan. Whether or not it’s the right fit for you will come down to your credit health, buying power, and current savings. 

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