FHA 203(k) Loan: What It Is and How It Works
Fixer-upper homebuyers often choose the Federal Housing Administration’s 203(k) loan to roll the cost of buying a home and making improvements to it into one loan, while taking advantage of more lenient qualifying requirements than other renovation loan programs offer. Understanding how the FHA 203(k) loan program works — and its limitations — will help you decide if it’s the best home improvement financing option for you.
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What is an FHA 203(k) loan?
An FHA 203(k) loan is a renovation mortgage insured by the Federal Housing Administration (FHA). It allows homebuyers to finance the cost of repairs, improvements or upgrades into one loan to buy or refinance a home.
A portion of the 203(k) loan balance is used to purchase the home or pay off an existing mortgage, and the remainder is placed in an escrow account to cover the rehab costs as work is completed, much like a construction loan. A 203(k) loan can be a fixed- or adjustable-rate mortgage (ARM).
There are two versions of the 203(k) loan: the limited and the standard. The limited loan is designed for smaller home improvement projects, while the standard loan helps fund larger rehabilitation projects. Here’s a brief overview of the difference between the two types of 203(k) loans:
Standard 203(k) loan
The standard 203(k) loan is for major renovation or remodeling projects. An FHA-approved 203(k) consultant must oversee the progress of the licensed contractor’s work from estimate to completion. This version of the 203(k) program allows for structural improvements including room additions, but still prohibits any “luxury” improvements like swimming pools or outdoor fireplaces.
What the FHA 203(k) consultant does
The 203(k) consultant is a state-licensed architect, contractor, engineer or inspector who serves as a liaison between the buyer, contractor and lender. Your consultant follows 203(k) guidelines to sign off on the release of funds as the work is finished, and the funds go directly from the lender to the contractor or another service provider.
Limited 203(k) loan
The limited FHA 203(k) rehab loan is geared toward minor improvements and repairs. No structural work is allowed, so you won’t be able to knock out walls or add rooms. In some cases, borrowers may be allowed to do some of the home improvement work, but a licensed contractor must be involved in the process. A 203(k) consultant isn’t required on a limited 203(k) loan.
FHA 203(k) loan: How it works
Because the lender is approving both your basic loan and your construction project, there are a few extra steps in the mortgage process.
- Complete an application and provide basic income, asset and credit information.
- Provide information about your planned renovations with an estimate prepared by a contractor.
- If you choose the standard 203(k) program, your lender will assign a consultant to review the plan, approve it and then oversee it during construction.
- The lender orders a home appraisal to determine the “after-improved” value.
- You’ll finalize your loan amount and the lender will finalize how the money will be given to contractors as the home is built.
- Once the home is complete, the appraiser does a final inspection and if everything is in order, your 203(k) funds are all used. According to FHA guidelines, repairs must be completed within six months for both the limited and standard program. Extensions may be granted on a case-by-case basis as long as payments are being made on time.
- Your loan converts to a “permanent” loan, and you start making payments based on your entire loan balance for the rest of the loan term.
How much can I borrow with a 203(k) loan?
The table below gives you an overview of how much you might be able to borrow with each 203(k) option.
| Loan type | Minimum improvement cost | Maximum improvement cost |
|---|---|---|
| Limited 203(k) loan |
|
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| Standard 203(k) loan |
| Lesser of
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What you can use an FHA 203 (k) loan for
Both types of 203(k) loans can be used to finance renovations on an eligible one- to four-unit property that’s more than a year old.
The limited FHA 203(k) mortgage only allows for smaller home improvements that can be completed within six months. The table below breaks down the types of projects suggested by the FHA guidelines for each type of 203(k) loan:
| Projects suggested for the limited program | Projects suggested for the standard program |
|---|---|
|
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Use a 203(k) loan to refinance your home
The 203(k) loan program can be used for major or minor improvements to your current home. If you have enough equity, you may even be able to roll in your closing costs. You can even pay off a non-FHA loan as part of the refinance, which may be good news if your credit scores have dropped below the 620 threshold required for conventional fixer-upper loans like the Fannie Mae HomeStyle® Renovation loan.
How to qualify for an FHA 203(k) loan
To get a 203(k) loan, you must meet the requirements for a standard FHA loan.
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- Credit score, credit history and down payment. If you’re making the minimum 3.5% down payment, you’ll need a 580 credit score. If your score is between 500 and 579, you have to put down at least 10%. At least three years must have passed since any foreclosures.
- Mortgage insurance premiums. You’ll pay upfront and annual mortgage insurance premiums. The upfront insurance is 1.75% of your loan amount, while the annual insurance ranges from 0.15% to 0.75% of your loan amount.
Good news in 2023: Lower MIP premiums
- Lender. You’ll need to work with an FHA-approved lender. Not all lenders offer FHA 203(k) loans, so it may take longer to gather quotes from at least three companies to determine the best FHA lender for your project.
- Loan limits. Keep your total loan amount below the FHA loan limit in your area. The 2023 loan limit for one-unit properties in most of the country is $472,030.
- Contingency reserves. Depending on the size of your project, your lender may require that you set aside up to 20% of the cost of the improvements for unexpected expenses that may arise. If you don’t have enough equity to roll them into your 203(k) loan, the lender may require proof you have the cash to cover them out of pocket.
- Home value. One unique feature of renovation loans is you borrow money based on your “after-improved” value. This gives you more borrowing power than other types of home improvement loans that consider your current “as-is” value. An approved FHA appraiser inspects your home, and reviews the work plan and cost estimate to determine how much the home will be worth when the renovations are finished.
Pros and cons of an FHA 203(k) loan
| Pros | Cons |
|---|---|
You can buy or refinance a home and renovate it with one mortgage You can qualify with much lower credit scores than conventional renovation loans allow You can borrow based on the value of your home after it’s improved You’ll pay lower rates than unsecured personal loans or credit cards | You’ll pay higher mortgage insurance premiums than a conventional renovation mortgage You must finance a home you intend to live in You may have to pay out of pocket for reserves to cover unexpected expenses Your loan amount is restricted by FHA loan limits |
Other renovation loan options
If the FHA program doesn’t work for your reno needs, consider one of these fixer-upper loan options (all of which allow you to qualify based on your home’s after-improved value):
Fannie Mae HomeStyle® renovation loan
If you have at least a 620 credit score and plans for a few luxury items in your renovation project, the HomeStyle renovation loan may be worth a look. An added bonus: You can borrow up to the conforming loan limit of $726,200 for a single-family home in most parts of the country.
Freddie Mac CHOICERenovation® and CHOICEReno eXPress® loan
Both of these programs allow you to finance the cost of buying and fixing up your home up to the maximum conforming loan amounts, similar to the HomeStyle renovation loan. However, the CHOICEReno eXPress loan gives you an easier qualifying option if your renovation costs are below 10% or 15% of the value of your home, depending on where you live. Both the Fannie and Freddie reno programs allow down payments as low as 3%.
VA renovation loan
The U.S. Department of Veterans Affairs (VA) backs VA renovation loans for military service members and their families. Eligible homebuyers may be able to buy a home with no down payment and add in the fix-up costs — up to 100% of the home’s after-improved value.
USDA renovation loan
If you’re buying or refinancing a fixer-upper in a rural area of the country, you might be able finance up to 100% of your renovation costs and repairs with the U.S. Department of Agriculture (USDA) renovation loan. Income limits apply, and the repair price tag can’t exceed $35,000.