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203(k) – The federally backed “renovation mortgage”
A 203(k) loan is a mortgage specifically designed to simplify the process of renovating a home for both new purchasers and existing homeowners. This special, federally insured loan can be used in two different scenarios:
- If you are purchasing a home requiring significant repairs, the 203(k) loan can fund the combined cost of the purchase and the repairs, all in one loan with a reasonable interest rate.
- If you already own a home that is in need of repair, the 203(k) loan can be used to pay for the improvements. In this case, you also have the option of refinancing the existing mortgage into the 203(k), leaving you with a single mortgage on both the house and the repairs, likely at a better rate than you’re currently paying.
Why should I consider a 203(k) mortgage loan?
A 203(k) mortgage is noteworthy because it’s insured (in other words, backed) by the federal government through the Federal Housing Administration (FHA), a part of the U.S. Department of Housing and Urban Development (HUD). You’ve probably heard of these two sets of initials somewhere along the way, and now you will understand a bit of what they can do for you.
Consider an example of a homebuyer who also wants to renovate the property. The 203(k) allows the would-be buyer to avoid the standard process of financing a fixer-upper, which is often difficult and costly, especially for someone who is not a real estate or construction professional.
Let’s say you’ve found a home for sale that is in need of repairs and modernization. You’ve negotiated a purchase price of $100K, but your research shows that with the required improvements, it will be worth $150K. You have also determined that these improvements will cost $20K.
You can see the potential benefit here. Once you complete the renovation, you will have spent $120K to get a home worth $150K, giving you a quick $30K boost in equity. The challenge is that you typically have to get separate loans for the $100K purchase amount and the $20K for repairs. And that’s where it can get tricky.
Consider it from the lenders’ point of view. They are taking more risk by lending a combined $120K against the home, because it’s only worth $100K before you have done the renovations. In order to be compensated for that additional risk, they will demand high interest rates and short repayment terms.
This is not particularly attractive to you, for a few reasons. You don’t want the extra hassle of having to get two separate loans, nor the much greater interest you’ll pay. And you really don’t want the added pressure of having to get the work done quickly so you can (hopefully) refinance the home at the expected higher value, allowing you to pay off the initial $120K in loans that are hanging over your head and rapidly coming due. What if something goes wrong with the repairs? What if the market changes and the new value of the home turns out to be much less than your estimate of $150K? You get the picture.
The FHA Has the Solution to This Problem
The federal government came to the rescue for you when it empowered the Fair Housing Authority (FHA) to create the 203(k) to help both borrowers and lenders, providing government-backed insurance for a single, long term loan that covers both the acquisition and renovation of a property. Borrowers save time and money, and because the government guarantees the loan, lenders are willing to loan you $120K on a house that’s only worth $100K at closing, before you’ve done the renovation.
Think of it this way – the 203(k) guarantee fills a big gap that would normally exist between the borrower and the lender, removing a lot of friction (and cost!) from the process. It puts more people in their own homes, and it provides a way to increase access to quality housing for more Americans. It’s an example of the government actually giving you something beneficial in return for your taxes, so take advantage of it if you can!
What are the advantages of a 203(k) loan?
- Low down payment. You only have to put 3.5% down if your credit score is above 580. Some lenders will also lend to borrowers with a credit score between 500 and 579. In those cases, you have to put down 10%
- By having one single loan for both the mortgage and renovation, your logistical hassles and possible stumbling blocks diminish significantly
- You can renovate your home as you’d like without having to dip into other resources
What are the disadvantages of a 203(k) loan?
- FHA mortgage insurance is required for the entire duration of the loan, adding a minor expense
- The strict approval process could prolong the time to complete the purchase
- The property must meet strict health and safety standards
- The loan amount cannot exceed the limit amount for the area the property is in
- Renovations must be completed within 6 months after closing
The Limited 203(k) – for less extensive repairs
The information above is about the Standard 203(k) mortgage. It can be used for just about any kind of improvements to the home, except for adding non-permanent changes or luxury amenities. The amount you can borrow for the repairs must be at least $5,000, but it can range up to much larger amounts, depending on where you live. It also requires that you use a 203(k) Consultant, who reviews the property to be sure it meets minimum HUD/FHA standards.
For smaller, mostly cosmetic repairs there is a simplified option called the Limited 203(k), also referred to as the Streamline 203(k). The application process is a streamlined version of the Standard, and the maximum you can borrow for financing repairs and renovations is $35,000, with no minimum amount. This loan is called Limited because you can only use it to pay for non-structural, minor property repairs or improvements, such as remodeling the kitchen, painting the interior, purchasing new carpet, etc. The Limited 203(k) does not require the use of a 203(k) Consultant, though you can use one if you choose. You also have to live in the property, and it can’t be vacant for more than 15 days.
Even with these restrictions, the Limited 203(k) covers a lot of people’s situations. If you can make it work for you, it’s worth looking into, because it will make things even simpler than the Standard 203(k).
Isn’t the process of getting a 203(k) loan really difficult?
You may have heard rumblings that, even if 203(k) loans can be a great deal, the process of getting one is difficult and slow, making you wonder if it’s worth the hassle. Yes, it’s true that there’s a bit of work required on your end. And yes, it’s worth it. There’s probably nowhere else you can turn to get such a good interest rate on a loan that covers both purchase and renovation. So a little effort is probably worth it.
There are 2 main parts of closing a 203(k) loan that you might find scary:
- Paperwork: It’s true, more paperwork is required for a 203(k) than a typical home mortgage. Fortunately this can be made a lot easier by working with lenders that specialize in the 203(k), such as our partners on the list above. They handle these loans every day, so they are expert at leading borrowers through the process, making it much smoother than with a lender that only handles occasional 203(k) loans.
- Time: A 203(k) loan can get held up by the process of finding contractors to bid on the renovation work. Once again, this obstacle can be largely removed by working with one of the 203(k) specialists we have identified above. They frequently have a network of qualified contractors in your area that they have worked with before. Both you and the lender can be confident you’re getting fair bids from reliable professionals you can trust to do the job right.
Don’t let your lack of knowledge about the 203(k) process stop you from pursuing one of the best financial benefits that is available to you. No home purchase, let alone one involving a renovation, is going to be without some effort on your part. The 203(k) makes your effort worthwhile by giving you everything you need in one stop, and at a very fair price.
Where do I get a 203(k) loan?
Not all mortgage lenders offer 203(k) loans, and even fewer specialize in them. It’s usually a good idea to check with lenders with deep experience in the field, especially if you’re doing your first 203(k). The list at the top of the page gives you some of the 203(k) specialist lenders that we think highly of. Look closely at the different providers, because they have different lending standards for credit score, income, property value, etc. It’s definitely not a one-size-fits-all process.
The key point to understand is that you must meet all the requirements of both the lender and the FHA/HUD program, and if you do, the government will guarantee your loan. This means the lender can make the loan knowing if that for any reason you don’t pay, the government will.
More detail on the requirements and process is below.
Some key details you need to know about the 203(k)
As with any government program involving large amounts of money, the 203(k) has a lot of fine print to wade through. Fortunately, most of it is fairly easy to understand. And for many homebuyers and homeowners, it’s not overly difficult to qualify for the loan.
We have assembled these details to put together a helpful list of answers to many of the key questions you are probably asking….or at least you probably should be asking!
What types of homes qualify for a 203(k) loan?
You may use a 203(k) loan for a single-family home, including a manufactured home, townhouse, row house, or condo. The home must be used as primary residence; you may not use the loan for a second home or investment property. The home must also be at least one year old, and the total value of the property cannot exceed the FHA loan limit for the area. Also, if there is a portion of the home that has non-residential uses, you can only use the loan for the residential part of the property.
How much can you borrow?
The FHA sets limits on how much you can borrow based on the area of the property. Generally, for the year 2020, the limit ranges from $331,760 for a one-family unit to $638,100 for a four-family unit in an area with lower median home sale price, and $765,600 for a one-family unit to $1,472,550 for a four-family unit in an area with a higher median home sale price.
What’s required to qualify for a 203(k) loan?
To qualify for a 203(k) loan, you must meet the following requirements:
- Minimum credit score of 500
- Minimum of 3.5% for down payment if your credit score is 580 or higher
- Minimum of 10% for down payment if your credit score is between 500 and 579
- Debt-to-income ratio (DTI) of under 50% (i.e. your total monthly debt payment must be under 50% of your pre-tax income, including debt you’re not actively paying
- Valid Social Security number
- Proof of U.S. citizenship, legal permanent residency, or eligibility to work in the U.S.
- Bank statements for at least the last 30 days
- Documentation for any deposits made during that time (usually pay stubs)
What renovations can you use a 203(k) loan on?
Depending on which loan type you get, there are different repairs and improvements that you can use your 203(k) loan on.
You can use the Standard 203(k) mortgage on most improvements costing over $5,000. This can range from a complete demolition, as long as the existing foundation remains in place, to a conversion of a property from a one-unit structure to as many as four units. There is a lot of flexibility in what you can do.
For the Limited 203(k) mortgage, you can only use the loan on minor improvements and non-structural repairs. These include eliminating health and safety hazards, repairing/replacing plumbing, AC, and electrical systems, repairing or installing new roofing, and more. The total rehab cost may not exceed $35,000, and unlike the Standard 203(k) loan, there is no minimum cost.
What renovations can you NOT use a 203(k) loan on?
For both the Standard and Limited 203(k) loans, you cannot use the loan on luxury items, improvements that do not become a permanent part of the property, or improvements that only benefit the commercial use of the property, if the funded property is also used for non-residential purposes. Luxury items such as swimming pools (although an existing swimming pool can be repaired), hot tubs, tennis courts, gazebos, and more are not covered.
For the Limited 203(k), there are additional restrictions. You cannot use the loan on major improvements that take more than six months to complete, require more than two payments to the contractor, or require architectural or work plans, and more. Some examples include converting the house to multiple units, adding rooms, changing the foundation, landscaping, etc.
How do you get a 203(k) loan?
There are more steps involved in getting a 203(k) loan than a traditional mortgage or refinance loan. Here is a high-level overview of the process:
- Find an eligible property that you want to purchase and renovate
- Reach out to a lender that provides 203(k) loans (we have a list on the top of this page) and get pre-approved by the lender
- Put together a sales agreement with 203(k) contingencies (e.g. contract is contingent on 203(k) mortgage approval) and make an offer on the property
- If you’re getting a Standard 203(k) mortgage, choose a certified 203(k) Consultant who’ll do an inspection, provide estimates, and determine what fixes are needed with you
- Select a licensed contractor to draw up bids (i.e. cost estimates) for the repairs
- The lender will order an appraisal that’ll provide both the “as is,” or current value of the home, and the future value of the home after all of the repairs
- Obtain final loan approval from the lender
- Once approved, a portion of the loan proceeds is used to pay the seller, or, if a refinance, to pay off the existing mortgage, and the remaining funds are placed in an escrow account and released as work is completed
- The contractor starts the construction work, which must be complete within 6 months of closing and inspections will take place throughout the construction period
- Once all work is completed and meets conditions after a final inspection, the funds are disbursed to you and all liens on the home are release
Note: You may do all of the work yourself and not hire a contractor, but additional documentation may be required for that.