FHA 203(k) Loan: Rehab Loans Explained

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Fixer-uppers can be transformed into fantastic places to live. They can also get expensive. In addition to your mortgage loan, you will often need to pay for repairs out of pocket or get a short-term, high-interest loan. What if you could combine your home purchase and the cost of renovations in a single loan? With an FHA 203(k) rehab loan, you can! 

FHA 203(k) loans (also known as renovation mortgage loans) let you purchase or refinance a home by combining the mortgage and repairs into a single loan with one monthly mortgage payment. 

This post will explain how FHA 203(k) rehab loans work, their requirements, and the pros and cons of getting one. 

What is an FHA 203(k) Rehab Loan?

Qualifying for a conventional loan can be difficult if you purchase a home needing serious repairs. Mortgage lenders often hesitate to approve a loan for these types of homes, leaving home buyers to search for alternative revenue sources, like hard money loans or private loans. 

Rehab loans solve this problem because the renovation costs are built into the loan. You can borrow up to 110% of the future value of your home or the purchase price plus repair costs — whichever is less, as long as it’s within the FHA loan limits for your area. For example, if your home’s purchase price is $300,000 and will require $25,000 in renovations, you can get an FHA 203k rehab loan for $325,000. 

You can also refinance your home with a rehab loan, provided you plan at least $5,000 in home improvements. You don’t even need a current FHA loan to do so!

How Does an FHA 203(k) Loan Work?

Getting an FHA 203(k) rehab loan is similar to any other home loan but with a couple of extra steps. 

1. Shop around

Not all lenders are approved to offer FHA 203(k) loans. Get quotes from a few lenders who can and figure out who can get you the best deal. Then, apply for a loan and get a pre-approval letter through them.

2. Find a property

Find a home you want to fix and let the seller know you’re getting an FHA 203(k) rehab loan in your offer letter. 

3. Work with a consultant

Consider working with an FHA 203(k) consultant, especially if your renovation costs are expected to be north of $30,000. A consultant can get detailed proposals from professional contractors, including cost estimates and the scope of work required. 

4. Work with a contractor

You cannot renovate the property yourself to get approved for an FHA 203(k) loan. You must hire a professional contractor. If you’re not working with a consultant, your contractor needs to draft a detailed proposal outlining the scope of work and the approximate cost.

5. Get a home appraisal

Your lender issues a home appraisal to determine the property’s value. Unlike a standard home appraisal, you’ll get a report for the appraised value before and after renovations.

6. The close and construction

You can complete the transaction as long as the home appraisal is aligned with the proposed loan. Once you do, contractors can begin renovating your new home. Your lender will guide you through this process because it also involves receiving bids from licensed contractors and some additional paperwork. However, that’s what your 203k approved lender is there for—to help you turn your fixer-upper into a place to call home.  

Types of FHA 203(k) Loans

There are two types of FHA 203(k) loans: limited and standard. Here are the distinctions between them:

Limited 203(k) Loans	Standard 203(k) Loans
Caps out at $35,000 for home renovations	Requires a minimum of $5,000 for home renovations
Mostly for non-structural, non-luxury repairs, like roof replacements, kitchen and bath remodels, HVAC upgrades, etc.	It can include some structural alterations, like turning a home into a duplex, improved accessibility for a disabled person, larger landscaping projects, etc.
Easier to get and less paperwork	Less common and more paperwork

What Can’t You Do With a 203k Loan

Regardless of the type of 203(k) loan you get, some restrictions apply to limited and standard loans. First, construction projects cannot take longer than six months to complete. May sure you’re working with contractors who understand your timelines and can work within them. You also can’t add luxury amenities like swimming pools or tennis courts. The only main restriction is for minor landscaping projects. Major landscaping projects are okay.

Requirements for an FHA 203k() Rehab Loan

As you might’ve assumed, FHA 203(k) loans are a subcategory of FHA mortgage loans and therefore have similar requirements, including:

• You must live in the home. FHA 203(k) loans aren’t meant for house flipping.
• You must be a U.S. citizen or a lawful permanent resident. 
• 3.5% minimum down payment of the combined total of the purchase price and renovation costs.
• A minimum credit score of 580. In some cases, you may get a loan if your credit score is between 500-579 if you put 10% down, but it’s less likely. 
• A debt-to-income ratio of less than 43%. In other words, if your pre-tax income is $4,000 monthly, your bills can’t exceed $1,720. 
• You cannot exceed the FHA 203(k) loan limits in your area. 

Benefits and Disadvantages of an FHA 203(k) Loan

Every loan has pros and cons, and FHA 203(k) rehab loans are no different. 

FHA 203(k) Rehab Loan Pros

• You can combine your purchase price with home repairs and enjoy a newly-renovated home.
• Lower down payment and credit score requirements than a conventional loan.
• Lower interest rates than other types of home improvement loans.
• Fast way to build equity. The price of distressed homes is often much less than their non-distressed counterparts. 
• Typically less competition for a property.

FHA 203(k) Rehab Loan Pros

• You can’t get approved for a loan if you’re looking for an investment property.
• You’ll need to pay private mortgage insurance (PMI).
• It requires more paperwork than a regular loan and takes more time to close.
• Typically, rehab loans are 0.75% to 1% higher than your standard FHA mortgage.  
• You’ll need to determine what repairs need to be made and determine if you have the budget for them, which requires more work. Also, licensed contractors are required to do the work. You cannot DIY and save on costs. 

FHA 203(k) Rehab Loans vs. Conventional Loans

FHA 203(k) loans and conventional loans have some overlap. They’re both used for primary residences, require similar debt-to-income ratios, and you can get loan-term loans (15, 20, and 30 years) using both. However, there are a few key differences between these loan types:

	FHA 203(k) Loans	Conventional Loans
Down Payment	Minimum 3.5%	Minimum 5% (typically)
PMI	Required	Not Required if you put 20% down
Credit Score Minimums(Usually)	580	620
Maximum Seller Contributions to Closing Costs	6%	9% if you put 20% down
What You Can Use the Loan For	Primary residence	Primary or secondary residence and investment properties

Using a 203k Loan to Refinance Your Existing Loan

Refinancing into a 203k loan to help pay for home improvements is a great way to get the renovations you want to be done. You don’t even need an existing FHA loan to do it! As with regular 203k rehab loans, you can choose between a limited or standard loan and must meet their requirements. 

You can refinance up to 96.5% of your total mortgage if your credit score is 580 or higher. However, a mortgage lender may have stricter requirements for you to follow. Do your research before refinancing with a 203k loan to see if it’s right for you. 

FHA 203(k) Loan Alternatives

Luckily, there’s no shortage of home loans available if you want to buy a fixer-upper. Here are some of your other options:

• Fannie Mae HomeStyle Loan – Works similarly to an FHA 203(k) loan, but has stricter requirements, including a 680 minimum credit score and a maximum debt-to-income ratio of 36%.
• Cash Out Refinance – If you already have equity in your home, you may be able to cash a percentage out to pay for renovations. 
• Home Equity Loan – You can get a second mortgage and receive a lump sum based on your home’s value.
• Home Equity Line of Credit (HELOC) – Similar to a home equity loan, but works like a line of credit. 

Are FHA 203(k) Rehab Loans Worth It?

Honestly, it all depends on your situation. FHA 203(k) rehab loans are a great way to build equity because your home’s value quickly increases. Also, they’re convenient because you don’t need to take out an additional loan, which will likely have a higher interest rate and require you to pay it back faster. 

However, real estate investors can’t use these loans, and there are some restrictions to what you can upgrade. Also, the higher interest rate (even though it’s just .75% – 1%) will really add up if you don’t refinance. 

That said, FHA 203(k) loans provide a great way to build equity and can help aspiring homebuyers turn fixer-uppers into a home. Often, that’s what ultimately matters. 

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.