FHA 203(k) Rehab Loan: What it is and How it works

A rehabilitation loan can be very appealing in today's competitive mortgage landscape. It gives buyers a chance to personalize a home from the beginning instead of having to settle for what they don't like and hoping they can customize it down the line.

Rehabilitation loans require a lot of work and patience and, in return, can provide less competition than a traditional home purchase. From the surface, it can seem too good to be true. That's why we're here to give you the full scope.

We've crafted this article to cover any question you may have about FHA 203(k) loans, plus some you've yet to think about. We'll talk about everything from loan use to eligibility. Let's get started!

The "203(k)" in the loan name refers to the National Housing Act section that authorizes this program.

Key Features of FHA 203(k) Loans:

• Available for Purchase or Refinance: Borrowers can use the loan to purchase a new property or to refinance an existing property they already own.
• Appraisal Based on After-Repair Value: The loan amount is determined based on the property's projected "after-repair" value, which considers the cost of repairs and renovations.
• Designated for Owner-Occupied Properties Only: The loan is designed for families who intend to occupy the property as their primary residence. Buyers cannot use the FHA loan as an investment property.
• Lower Down Payment: The minimum down payment required for an FHA 203(k) loan is typically lower than conventional mortgage requirements.
• Standard and Limited 203(k) Loans: There are two types of FHA 203(k) loans—standard 203(k) and limited 203(k) (also known as the 203(k) streamline). The standard 203(k) loan is used for extensive renovations, while the limited 203(k) loan is suitable for smaller projects.

FHA 203(k) Project Ideas

An FHA 203(k) loan can be used to finance various eligible products and improvements for a property. Here are a few home project ideas that you could tackle with the 203(k) loan:

Who qualifies for an FHA 203(k) loan?

Overall, qualifying for an FHA 203(k) loan does not differ much from qualifying for any other type of FHA loan. We have a comprehensive guide to FHA qualifications here, but let’s touch on some essential 203(k) qualification requirements.

FHA 203(k) Loan Credit Requirements

Typically buyers need a credit score of at least 500 to qualify for an FHA 203(k) loan.

FHA 203(k) Loan Down Payment

If your credit score is 580 or higher, you will need a minimum down payment of 3.5% to qualify for an FHA 203(k) loan. In this case, the 3.5% is to cover the home price as well as the renovation cost. For a $325,000 home with a renovation cost of $75,000, a down payment of $14,000 would be required.

If your credit score is between 500 and 579, you must make a minimum down payment of 10%. For a $325,000 home with a renovation cost of $75,000, a down payment of $40,000 would be required.

FHA 203(k) Loan Limits

• Standard 203(k) Loan:
  • The maximum loan amount is generally the same as the FHA loan limit for the area where the property is located.
• Limited 203(k) Loan:
  • The maximum renovation loan amount is $75,000.
  • This loan is designed for smaller, less extensive renovations.

FHA 203(k) Loan Process

The 203(k) loan process is unique compared to other loan product types. To simplify it for you, we've summed up the FHA 203(k) loan process in 10 steps. Starting with loan eligibility, we'll cover everything through the final inspection.

Step #1: Determine Eligibility

To qualify for an FHA 203(k) loan, borrowers must meet the FHA's credit and income requirements. The property must also meet specific standards and be eligible for FHA financing.

Step #2: Find a Lender

Find a mortgage lender approved to originate an FHA 203(k) loan. Like many other FHA-approved lenders, First Residential does not currently offer any version of the 203(k) loan. Finding lenders willing to offer this type of loan can often be a buyer's largest roadblock.

Step #3: Property Selection

Identify a property that requires renovations and is eligible for FHA 203(k) financing. This could be a fixer-upper or an existing property you want to improve.

Step #4: Loan Pre-Approval

Get pre-approved for the FHA 203(k) loan by providing the lender with the necessary financial and personal information. Preapproval will give you an idea of the loan amount you qualify for and help you set a budget for the purchase and renovation.

Step #5: Property Appraisal and Work Estimate

An FHA-approved appraiser will assess the property's current condition and determine its after-repair value. Additionally, you will work with a lender-approved licensed contractor to provide detailed estimates of the repairs or renovations you plan to undertake.

Step #6: Loan Application & Processing

Submit a formal loan application to the lender, including all the documentation for the loan process. The lender will process your loan application, review your financial information, and verify the property's FHA 203(k) financing eligibility.

Step #7 Underwriting and Approval

The lender's underwriting team will evaluate your application, credit history, and property information to determine if you qualify for the loan.

Step #8 Loan Closing

You will go through the loan closing process if your application is approved. You'll sign the loan documents during closing, and the property will be transferred into your name.

Step #9 Renovation Process

The renovations can begin after closing. Using a lender-approved contractor is required for the FHA 203(k) loan, meaning the updates cannot be done yourself. The funds for the repairs and improvements are held in an escrow account, and the contractor is paid from this account as the work progresses.

Step #10 Final Inspection

Once the renovations are complete, the property will undergo a final inspection to ensure all the work has been completed according to the agreed-upon plan and meets FHA standards.

Working with an experienced loan officer and knowledgeable contractor is critical to ensure a smooth and successful renovation project.

203(k) Appraisal

As with all other FHA loan types, an appraisal is required for the 203(k) loan. However, the appraisal required for this loan has a few nuances. Unlike other FHA loan types, during the 203(k) appraisal, the home's market value is designated the "as-is value" because further upgrades are anticipated. During that process, the appraiser also examines the scope of the requested upgrades and ensures the home will still meet FHA minimum property standards after updates.

FHA 203(k) Pros and Cons

The decision to purchase using the 203(k) program will vary depending on the individual buyer’s situation, but here are some general pros and cons to think about when using an FHA 203(k) loan:

FHA 203(k) Pros and Cons

The decision to purchase using the 203(k) program will vary depending on the individual buyer’s situation, but here are some general pros and cons to think about when using an FHA 203(k) loan:

Advantages of the FHA 203(k) Loan

One Loan for Purchase & Renovation

The FHA 203(k) allows homebuyers to finance both the purchase of a property and the cost of necessary renovations or repairs with a single loan. It can be a great idea for buyers who want to customize their homes.

Flexible Credit Score Requirements

The FHA 203(k) loan is attractive for buyers due to its flexible credit score requirements. Borrowers with credit scores as low as 500 can qualify for the FHA 203(k), making homeownership and renovation financing more accessible.

Improved Home Value

The FHA 203(k) loan offers a significant advantage to homebuyers by providing the opportunity to improve the value of their purchased property through renovations and upgrades. By financing these improvements with the loan, buyers can enhance the home's overall value, potentially leading to greater equity and increased market appeal if they decide to sell in the future.

Disadvantages of the FHA 203(k) Loan

Unwilling Lenders

One potential drawback of the FHA 203(k) loan is that some lenders may be unwilling to offer this specialized loan program. As a result, homebuyers may find limited options when searching for a lender. First Residential, for example, does not currently provide financing for FHA 203(k) loans.

Contractor Required & Subject to Lender Approval

With an FHA 203(k) loan, buyers must work with a contractor to complete all renovation projects, and the lender must approve the contractor. This requirement ensures that qualified professionals handle the renovations and that the work is completed according to the agreed-upon plan and budget.

Limited to Owner Occupied Residences

The FHA 203(k) loan is only available for owner-occupied residences, meaning the borrower must plan to live in the property as their primary residence. This restriction excludes investors or buyers looking to purchase properties for rental or investment purposes from using the loan.

It's crucial for buyers to carefully assess their individual needs, financial situation, and renovation goals to determine if the FHA 203(k) loan aligns with their unique circumstances and best serves their long-term homeownership plans.