An Introduction to the FHA 203(k) Loan
Are you interested in buying a fixer-upper, but don't have the cash to remodel it? Or maybe you have saved money for remodeling, and you've found a house you love, but your lender won't allow you to buy it because the house isn't considered habitable without toilets. There are always properties on the market that weren't maintained by cash-strapped former owners, were treated poorly by renters or were deliberately trashed by formers owners who were foreclosed on. Shouldn't there be a way for someone like you to fix up these neighborhood eyesores and bring them back to life?
A Gift from the Government
There is a way to buy a fixer-upper, and it's brought to you by the federal government. The Federal Housing Administration's rehab loan product, the FHA 203(k) loan, was designed for individuals who want to rehabilitate or repair a damaged home so they can live in it as their primary residence. These loans are endorsed by the government to encourage lenders to offer what would otherwise be considered a risky loan product. Because of the risk and expense involved, rehab projects are normally handled by professional real estate investors who can buy properties with cash and therefore don't need any bank to approve the property's condition.
This article will describe how much money you need to save up, the two different types of 203(k) loans, eligible properties, eligible repairs and more— in short, what you need to know to see if this type of loan is right for you. (For background reading, see: Insuring Federal Housing Authority (FHA) Mortgages.)
How Much Cash You Need
The FHA 203(k) loan lets you include the money needed for repairs and related expenses (materials and labor) in the loan. If you wanted to buy a home where the kitchen had been ripped out, you could include in the loan the price of new cabinets, countertops, flooring, a fridge, stove, oven, microwave, sink, dishwasher, garbage disposal, and the cost to design, permit and install it all. The loan can also include a 10-20% contingency reserve for expenses above and beyond your repair estimates. You can also get up to six months' worth of mortgage payments included to cover the mortgage while you're renovating the home so that you won't have to make a double housing payment.
Types of 203(k) Mortgages
There are two types of FHA 203(k) mortgages: regular and streamlined (also called "modified"). Regular is for properties that need structural repairs; streamlined is for those that need only non-structural repairs. Either can be used for purchase or refinance.
For the regular 203(k) purchase loan, the maximum mortgage amount is based on the lesser of the as-is value of the property plus rehab costs or 110% of the expected value of the property after rehab. This means that you wouldn't want to buy a house with an as-is value of $150,000 if it needed $25,000 in repairs unless you had an extra $10,000 in cash because the most you could borrow would be $165,000 (110% of $150,000). The streamlined loan allows homebuyers to add a maximum of $35,000 to the purchase price to pay for improvements. (To learn more, see: Mortgages: How Much Can You Afford?)
Of course, in any case, you have the income to support the mortgage - you can't just take out a loan for a certain amount because the house warrants it.
FHA 203(k) loans are intended for owner-occupants, not investors. The following types of properties are eligible:
- Single-family to four-family dwellings
- Existing construction that has been completed for at least one year
- Teardowns, as long as part of the existing foundation will remain
- An existing house that will be moved to a new foundation
- The residential portion of a mixed-use (commercial/residential) property
- FHA-approved condos
With such a wide range of qualifying properties, almost anyone can find the right property that will qualify for a 203(k) loan.
Financing Conditions and Allowable Rehab and Repair Expenses
Regardless of what work you may think the house needs, the lender and FHA have their own requirements that you'll also have to meet. The U.S. Department of Housing and Urban Development (HUD) "requires that properties financed under this program meet certain basic energy efficiency and structural standards" to "comply with HUD's Minimum Property Standards (24 CFR 200.926d and/or HUD Handbook 4905.1) and all local codes and ordinances."
The energy efficiency standards include caulking, insulation, and ventilation as well as using the correct size heating and air conditioning systems for the home. The home is also required to have smoke detectors adjacent to each sleeping area.
You might be surprised by the variety of home repairs and improvements that can be financed with the 203(k) loan. These include, but are not limited to, the following:
- room additions
- site grading and drainage
- bathroom remodeling
- kitchen remodeling, including appliances
- finishing an attic or basement
- structural alterations and repairs
- adding or decreasing the number of units in a dwelling (e.g., single family to duplex)
- new siding
- second story additions
- elimination of lead-based paint problems
- heating, ventilation, and air conditioning systems (HVAC)
- energy conservation
- disabled access
The FHA does not allow "luxury items" such as tennis courts, swimming pools, hot tubs and barbecue pits to be financed with a 203(k) loan, but some items that you might think of as luxuries, such as whirlpool bathtubs, are actually allowed. Talk to your lender about the specific improvements you want to make to see what you can finance.
Completing the Rehab
Once you complete the purchase and the home is yours, you can start the repairs and remodeling. The FHA requires all repairs to be completed within six months, though lenders can require a shorter timeframe.
You'll begin making mortgage payments right away like you would on any home. After all, you own it—it doesn't matter if you're not living in it yet. However, as mentioned earlier, you can finance your first few mortgage payments.
The rehab and repair money is placed in an escrow account and released as the work is completed and inspected to ensure HUD approval. HUD must also approve the finished product once all work has been completed.
Problems to Avoid
Many lenders don't do FHA 203(k) loans, whether because they don't know how or don't want to do the extra paperwork. Working with a lender who isn't experienced with FHA 203(k) loans is something you should avoid - the process is complex enough as it is. Don't give yourself any headaches by working with someone who doesn't know what they're doing.
Also, make sure you don't overinvest in the home —don't spend so much on repairs and improvements that you won't be able to recoup your costs if you sell the house one day. Look at the average sale prices of move-in ready homes in your neighborhood and try to put your home within this range. You don't want to own a $300,000 home in a neighborhood of $200,000 homes because most people who can afford a $300,000 home will want to live in a nicer neighborhood where all the homes are comparably valued.
FHA 203(k) loans have a longer closing period than other types of loans. They usually take 60 to 90 days to close, compared to the 30 to 45 days that are common for other loans, including regular FHA loans. If you're in a hurry to move, the 203(k) loan is not the product for you. You can also expect to pay a higher interest rate because of the increased risk associated with home-improvement loans. (For more, check out Mortgage Points – What's The Point?)
These loans are also more work for lender and require specialized loan knowledge, so it can be harder to find a lender that will work with you. The application and renovation processes are lots of work for homeowner, and there is lots of red tape involved. Some borrowers have reported delays in receiving their rehab funds, which adds additional stress to the process.
The Bottom Line
Though it can be more work to find a lender who does FHA 203(k) loans and to complete both the application and renovation processes, the extra effort can pay off. This loan product can make it possible for you to buy that perfect house that just needs some reconditioning to be livable again. It can also make it possible for you to make the leap from renting to home ownership since there might be a fixer-upper out there in your price range when there aren't any move-in ready homes you can afford. (For more, see Are You Ready To Buy A House?)