What is an FHA 203(k) loan?
It’s one loan for two purposes: buying and renovating a home. Like all FHA loans, a 203(k) is a government-backed mortgage. That guarantee by Uncle Sam delivers significant benefits to the borrower and comes with specific requirements.
FHA 203(k) Loans Explained
The Federal Housing Administration (FHA) created the 203(k) program in 1978 to assist low- to moderate-income families in buying older homes that need repairs in established communities. The loan program still follows that core idea; 203(k)s can have lower down payments and more flexible qualification criteria than other loan types.
With a 203(k) loan, a single amount covers the costs of purchasing the home and financing its renovations. That eliminates two issues people who buy fixer-uppers often face: the need to qualify for two loans (purchase and renovation) and any reluctance mortgage professionals may have financing homes in disrepair.
How an FHA 203(k) Works
FHA 203(k) loans can be fixed-rate or adjustable-rate mortgages.
After approval, the loan amount splits. The money for the purchase goes to the home seller at closing; the renovation funds go into an escrow account. Payments from that account go to contractors in stages until the work is complete.
If a home is uninhabitable, the renovation portion of the mortgage could cover temporary housing for the borrower during the rehabilitation period.
You can also use a 203(k) for refinancing. Here, the 203(k) loan pays off the existing mortgage, and the balance goes toward renovation projects. Even if you have no equity in the home, you can refinance if the improvements cost more than $5,000.
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The Two Types of FHA 203(k) Loans
There are limited 203(k) loans and standard 203(k) loans.
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- Limited FHA 203(k) loans are for home renovations that cost less than $75,000 (set by the FHA in 2024). You can’t make major structural changes with a limited 203(k). It’s for moderate upgrades such as kitchen remodels, new carpeting, and roof repairs. Work has to end within nine months of the closing date.
- Standard FHA 203(k) loans are for home renovations that can include structural changes. With a standard 203(k), there is no maximum amount for renovation costs. However, the loan must conform to the FHA mortgage limit for the area. Work has to end within one year of the closing date.
FHA 203(k) Requirements
The process requirements include:
- A consultant. With a standard 203(k), an approved consultant must oversee the renovation, from the initial estimate to monitoring progress until completion. With a limited 203(k), the consultant is optional.
- An appraisal. An approved appraiser will determine the as-is and after-improved value of the property.
- Inspections. As the renovation progresses, the borrower and consultant jointly inspect work and sign off on draw releases to pay the contractors.
Eligible properties include:
- Single-family homes.
- Single-family homes with ADUs (an Accessory Dwelling Unit on the property with a separate living space).
- Two- to four-family units.
- Townhomes and condominiums.
- Mixed-use properties that are at least 51% residential.
How to Apply for a 203(k) Loan
Your mortgage professional can help you with an approved list of local consultants, appraisers, contractors, and loan limits for your area. The borrower requirements for loan approval include:
- Credit score. The FHA sets a credit score minimum of 500. However, with a low score, you will probably need to put down 10% or more. A credit score of 580 or higher may qualify you for a down payment as low as 3.5%. The average credit score for FHA borrowers is around 645.
- DTI. The FHA guidelines suggest a debt-to-income (DTI) ratio of 50% or less.
- PTI. The FHA also considers your payment-to-income (PTI) ratio. It compares your monthly income to your proposed mortgage payments. FHA guidelines suggest a PTI of 40% or less.
- Income requirements. There is no minimum or maximum salary for qualification. You will probably need proof of employment, such as W-2s. You may need to show tax returns for the past two years. Mortgage professionals will wish to see financial documents such as bank statements to evaluate your financial profile.
- Debt. Delinquent federal debt, court judgments, owed taxes, or debt associated with past FHA mortgages could be disqualifiers.
The Pros and Cons of 203(k) Loans
On the pro side:
- Low down payment. Even borrowers with credit issues could qualify for a 3.5% down payment on a 203(k) loan.
- Credit score requirements. FHA requirements are generally lower than those for conventional loans.
- Attractive interest rates. As the U.S. government insures FHA loans, mortgage professionals have lower risk and often give favorable rates to 203(k) borrowers.
- Streamlined financing. One loan with one closing and one repayment schedule covers what could otherwise be a more complicated (and more expensive) process.
- Expanded choice. Broadening your search to include properties that need work opens up a wider range of homes to choose from.
- Potential savings. Fixer-uppers can be more affordable than move-in ready homes. After the improvements, you could see a significant financial benefit.
On the con side:
- Time and energy. Almost anyone who has gone through home remodeling knows about the time and effort home projects demand.
- Closing time. With 203(k)s, there are estimates, contractors, and appraisals, all involving government paperwork. The extra steps may cause closing to take longer.
- Insurance. The FHA requires an upfront mortgage insurance premium and monthly insurance payments if the down payment is less than 20%.
Who can benefit from a 203(k) loan?
Limited and standard 203(k) loans are for families and individuals looking to finance their primary residences. Real estate investors and house flippers don’t qualify for 203(k)s. You don’t have to be handy; licensed contractors do all the work covered by the loan.