FHA 203(k) Loan

What is 'FHA 203(k) Loan'

An FHA 203(k) loan is a type of government-insured mortgage that allows the borrower to take out one loan for two purposes – home purchase and home renovation. An FHA 203(k) loan is wrapped around rehabilitation or repairs to a home that will become the mortgagor’s primary residence.

Also known as FHA Construction Loan.

BREAKING DOWN 'FHA 203(k) Loan'

The Federal Housing Administration (FHA) is not a mortgage lender, rather it is a mortgage insurer. The administration was created during the period of the Great Depression which saw a high rate of foreclosures and defaults. The FHA served to incentivize banks to give home loans to low- to medium-income earners, individuals with low credit scores, or first time home buyers with no credit history. This helped to stimulate the economy as people that would normally not be approved for a loan were being issued mortgages. The FHA loan was created to insure these types of mortgages so that in a case were the borrower defaults, the FHA would step in to cover the payments, thus, minimizing the default risk faced by the lender. As compensation for insuring the mortgage, the borrower pays a monthly or annual mortgage insurance premium to the FHA.

In a bid to revive neighborhoods that were run down, the FHA introduced the 203(k) program. High income earners most likely prefer to stay in newer and more developed areas of a city, leaving the investments in poor-shaped neighborhoods to property investors who purchase homes in these areas, add some minor renovations, and flip them for a higher price to earn a premium profit. For low income earners that want to own a property but would not qualify for a standard loan, the FHA 203(k) loan program provides a way.

The FHA 203(k) loan encourages families in the low to moderate income bracket to purchase homes that are in dire need of repairs – especially homes that are situated in old communities. The program allows an individual to buy a home and renovate it under one fixed- or adjustable-rate mortgage. The amount that is borrowed includes the purchase price of the home and the cost of renovation, including materials and labor. The loan may also cover temporary housing funding (if needed) which could be in the form of rent for the period that the house is under rehabilitation. The dual purpose loan eliminates the need for a borrower to make two separate applications for a mortgage and a loan for home renovation, either of which may not be approved by the bank or may come at a higher combined cost.

Normally, lenders are unwilling to offer a mortgage for a property in need of major repairs following to their safety and livability standards. FHA 203(k) loans, which are government-backed, provide reassurance to lending institutions since the costs to renovate the home is included in the mortgage package. The renovation fees are placed in an escrow account and disbursed as payment to the contractors as the work is completed. Complete renovation of the home should not take more than six months as outlined in the FHA guide for a 203(k) loan.

Types of 203(k) Loans

There are two types of 203(k) loans – Streamline 203(k) and Standard 203(k). A home that does not require much work on it would usually be paid for using the streamline 203(k). This option does not include structural work on the home such as adding new rooms or landscaping, and the home must be habitable throughout the renovation period. Repairs under the streamline 203(k) are capped at $35,000. The standard 203(k) includes any extensive repairs and structural work that needs to be done in the home with no capped repair cost, but minimum amount that can be borrowed is set at $5,000.

Some of the repairs that an FHA 203(k) loan covers include:

  • Plumbing
  • Flooring
  • Painting
  • Heat and Air Conditioner systems
  • Bathroom and kitchen remodeling
  • Improvement of health and safety standards
  • Landscape improvements
  • Implementing access tools for disabled persons
  • Energy conservation systems' addition
  • Window and door replacements

Renovations that are considered extravagant or luxurious such as pools, or improvements that would not be a permanent part of the property are not covered under the FHA 203(k) loan. The loan applies only to individuals and families who intend on making the property their primary residence. This means that real estate investors and house flippers do not qualify. The work carried out must be contracted to licensed handyman, and must not be done by the mortgagor.

Like other FHA loans, an individual can make a down payment of only 3.5%. Since the loan is insured by the FHA, lenders may offer lower interest rates for a 203(k) loan compared to what borrowers may be quoted elsewhere. Interest rates will vary for each borrower depending on his or her credit history. Although the FHA allows individuals with credit scores as low as 580 to apply for a 203(k), some lenders might require a higher score of 620 to 640 to issue the loan. This is still lower than the 720 score required for a standard mortgage.

Downsides to an FHA 203(k) Loan

The FHA 203(k) loan is not without its costs. An upfront mortgage insurance premium (UFMIP) has to be paid every month by the borrower. A supplemental origination fee may also be charged by the lending institution. In addition to the financial costs to the borrower, the rigorous paperwork required and the lengthy time it takes to hear back from the FHA and lender are factors to consider when applying for this program. Overall, an individual with a low credit score seeking to own a home that may need to be fixed and modernized may realize that the FHA 203(k) has great benefits to it that outweigh its costs.

It is important to note that the FHA is not a lender, but a mortgage insurer. It is also not a home insurer or warranty provider. Home buyers still need to purchase home insurance and warranties for their home and property.