FHA 203(k) Loan: How Does It Work? | Requirements 2024

Editor
January 2, 2024

If you have found a home you love, but it’s in bad shape, the FHA 203k loan may be the perfect way to buy and renovate, simultaneously.

No scrambling around before closing trying to repair the home so the bank will lend on it. No pounding the pavement looking for a second mortgage to finance repairs. No living with leaky roofing for five years while you save up the money to fix it.

A 203k loan can take care of these repairs and more with one loan transaction.

Check your FHA 203(k) eligibility. Start here (Sep 16th, 2024)

In this article:

What is an FHA 203(k) loan?

The Federal Housing Administration (FHA) offers the 203k loan as an alternative to conventional construction financing.

Traditional construction loans provide only temporary financing to cover construction costs. Construction loan balances must be refinanced, with a permanent mortgage loan, once construction is complete. This means builders need to get two consecutive mortgages.

The FHA’s 203k program combines both these financing steps into a single loan, but the loan won’t finance the construction of a brand new home — only the renovation of an existing home.

For some buyers, this type of mortgage offers a perfect in-between — a chance to update and customize an existing structure, creating a modern home without starting from scratch with new construction.

The two types of FHA 203(k) loans

Before we continue, it’s important to know the FHA 203k program includes two loan options:

  • Full 203k, sometimes called a full rehab loan
  • Limited 203k, also known as a Streamline 203k

This article will focus on the Streamline 203k loan, since it is the most popular type, and will suit most homeowners who are looking to buy a fixer-upper. Additionally, many more lenders offer the Streamline 203k program.

Below are some basic differences between the 203k sub-types.

Streamline 203k:

  • No structural changes to the home allowed
  • A maximum of $35,000 can be financed for repairs

Full 203k:

  • Structural changes are allowed. In fact, the home can be leveled and rebuilt. (If a home is demolished, a portion of the existing foundation system must remain in place)
  • No maximum repair limit as long as the entire loan is below FHA’s maximum loan amount for the region

Check your FHA 203(k) eligibility. Start here (Sep 16th, 2024)

How does the 203k program work?

The FHA 203k loan is part of the popular FHA loan program, which is operated by the U.S. Department of Housing and Urban Development (HUD). By insuring private mortgage lenders, the FHA loan program helps people who have lower credit scores and smaller down payments qualify for affordable mortgage loans.

But there are limits: FHA-financed homes must serve as the buyer’s primary residence — and new homes must meet the FHA’s requirements for safety and functionality. Sometimes, this is difficult, especially when a home is older or has not been maintained properly.

203k loans were originally designed to help buyers solve this problem, to pay for upgrades needed to improve the structure without having to get two loans.

Buyers end up with one fixed-rate FHA loan and a home that’s in much better shape than when they found it. But what happens along the way?

203k opens an escrow to pay for repairs

Before the 203k loan closes, loan officers set up an escrow account to hold money set aside for repairs. This allows the loan to close before construction begins. This is important because most sellers won’t allow construction to be done prior to the sale closing.

This also prevents buyers from making repairs on a home they haven’t officially bought yet, a strategy that can backfire.

Normally, the licensed contractor who has been hired to make the repairs gets paid half of the costs upfront and the other half once repairs are complete. This ensures that the contract has enough money to start, but doesn’t bail on the project prior to completion.

The repair costs are determined by a finalized, set-in-stone bid prior to the closing of the loan. For repairs totaling more than $15,000, a 203k inspector makes sure the work is complete to FHA standards when all the work is complete. If the total cost of your repairs is less than $15,000, you won’t need to have the completed work inspected.

An FHA 203k loan example

Let’s say you’re buying a $270,000 home that needs $30,000 in repairs. An ordinary FHA loan or a conventional loan wouldn’t finance more than the home’s value. You’d need a $270,000 loan to buy the home and a separate $30,000 home improvement loan for the repairs.

With 203k, you could finance the entire $300,000 into a single loan with a 3.5% minimum down payment, which comes to $11,500. At closing, the home’s seller would receive $270,000 to cover the sales price. The other $30,000 from the loan would go into escrow.

As repairs begin, your licensed contractor would receive half the money — $15,000. Then, when repairs are complete and approved by the FHA, which must happen within six months of closing, the contractor would receive the remaining $15,000.

At this point, your loan will work like any other FHA loan. You’d move in and start making mortgage payments.

Seems simple enough, right? It is simple from a broad point of view. Up close, there are several rules and regulations to work through, outlined below.

Check your FHA 203(k) eligibility. Start here (Sep 16th, 2024)

FHA 203k loan requirements

The 203k loan program follows FHA rules and it follows an extra layer of rules that govern the home improvement portion of the loan.

First, let’s go over the general FHA loan requirements:

  • Credit score requirement: Mortgage lenders accept borrowers with credit scores as low as 580. Some lenders will allow lower scores on a case-by-case basis
  • Minimum down payment: 3.5% for borrowers with credit scores of 580 or higher; 10% minimum down for borrowers with scores below 580
  • Debt-to-income ratio: Most lenders will accept DTIs as high as 45%
  • Mortgage insurance premium: FHA loans require an upfront mortgage insurance premium payment of 1.75% — a fee that’s normally added to the loan amount. And, most FHA borrowers pay an annual rate of 0.55% which is added to monthly payments
  • Property use: The home must become the buyer’s primary residence and not a second home or investment property
  • FHA loan limits: In most areas, FHA loans can’t exceed $472,030; caps go higher in high-value real estate markets

In addition, the home must meet HUD’s livability standards, and that’s where 203k shines. If the home needs work, 203k can finance that cost along with the home purchase price.

203k-specific loan requirements

Now for the layer of rules that are specific to the renovation costs:

  • Age: The home you’re buying must be at least 1 year old. This makes sense. Normally, homes less than a year old don’t need significant rehabilitation
  • Budget: The Streamline 203k will not finance more than $35,000 in repairs. For a more extensive project, check out the Full 203k
  • Credentials: The contractor who repairs the home must be licensed by the local jurisdiction and all repairs must adhere to local building codes. The contractor’s bid has to follow FHA guidelines
  • Timeline: All repairs must be finished within six months of closing
  • Scope of work: Not all home repairs can be financed into a 203k loan

We’ll get to the list of allowed and not-allowed 203k home repairs next.

Related: Complete guide to home renovation loans

Streamline 203k: Allowable and non-allowable repairs

Many buyers are surprised at what the 203k allows them to do. This loan can be used solely for cosmetic purposes — not just when a home is in severe disrepair.

You can remodel a kitchen or bathroom, adding amenities like granite countertops and high-end appliances. The repairs don’t even need to be necessary to make the home eligible for FHA financing.

In other words, if a home has a functional kitchen, but it’s outdated, the buyer could use a 203k loan to remodel cabinets and countertops, upgrade appliances, and the like, with a 203k loan.

Keep in mind repairs can’t be structural when using the Streamline 203k. This means foundations, load-bearing walls, etc. can’t be altered. You couldn’t change the floor plan of the home, for example.

If the property you are looking at needs structural repairs to qualify for financing, you will need to use a Full 203k instead of a Streamline 203k or find a different property.

Acceptable Streamline 203k Repairs:

  • Roofs, gutters, and downspouts
  • HVAC, plumbing & electrical
  • Accessibility improvements
  • Lead-based paint stabilization
  • Mold abatement/termite repairs
  • Asbestos removal (must be done by a licensed asbestos expert)
  • Basement finishing/remodeling (non-structural only)
  • Septic system/well repair
  • Flooring (not including subfloor which is considered structural)
  • Kitchen/bathroom remodels
  • Painting
  • Weatherization
  • Appliance purchase and install
  • Landscaping

Check your FHA 203(k) eligibility. Start here (Sep 16th, 2024)

203k Non-Allowable Repairs

There are some amenities FHA deems as “luxury” items or items not permanently affixed to the home, which are not allowed:

  • Barbecue pits
  • Bathhouses
  • Dumbwaiters
  • Exterior hot tubs, saunas, spas
  • Outdoor fireplaces (although indoor fireplaces are allowed)
  • Swimming pools
  • Satellite dishes
  • Tennis courts
  • Alterations to improve commercial use of the property

The FHA 203k loan process

Here’s a breakdown of the general 203k loan process:

  1. The buyer finds a home they like, but it’s in disrepair.
  2. The buyer talks to their loan professional about the FHA 203k. Although they were pre-approved for regular FHA or conventional financing, they most likely need to be re-approved for a 203k loan. The loan professional issues another pre-approval based on the estimated purchase price and repair costs, plus other 203k-related fees.
  3. The buyer will find a general contractor to work up a detailed bid for all repairs. When the bid is complete, the buyer and lender receive a copy.
  4. An appraisal is ordered, which will reflect the future appraised value of the home — its value after repairs are complete.
  5. The lender submits the bid, appraisal, and all borrower income, credit, and asset documentation to underwriting.
  6. The underwriter issues an approval, usually with conditions needed from the buyer and the contractor.
  7. Once all conditions are received, the buyer signs the final loan documents. The lender funds the loan. Part of the loan funds are put into an escrow account, which holds the money for the repairs.
  8. 50% of the repair costs are issued to the contractor upfront. The other 50% will be paid to the contractor when all work is complete.
  9. The contractor has six months to complete the work.
  10. When the work is complete, the remaining repair costs are issued to the contractor.
  11. The escrow account is closed. The buyer has a home that is 100% complete, and one loan with one interest rate and one monthly payment.

Check your FHA 203(k) eligibility. Start here (Sep 16th, 2024)

203k breakdown of costs

By rule, a Limited or Streamline 203k can’t include more than $35,000 in repair and renovation costs. In reality, you should try to keep the costs closer to $30,000.

Why? Because that $35,000 budget must also include additional fees, including:

  • 203k Inspection fees: 2 inspections at $150 each. These ensure that the work is being done to FHA standards.
  • 203k Title update fee: $150. This fee protects the title in case the builder puts any liens on the property for disputed pay regarding the construction work on the home. If any liens are placed on the home, this fee ensures the FHA loan will remain in the first position on the title.
  • 203k Supplemental Origination Fee: 1.5% of the rehab costs, or $350, whichever is greater. This fee is charged for the extra work involved in setting up and managing the escrow account.
  • 203k Contingency Reserve: This is usually 10% of the final repair bid, but can be as high as 20%. This is held in the 203k escrow account in the case of cost overruns on the project.

As part of the 203k process, you will need to sign the FHA 203k Worksheet, also called the HUD-92700. This form is a breakdown of all loan costs, 203k fees, purchase price, repair bid amount, final loan amount, etc. Your lender will provide this form.

What If I Exceed the Repair Cost Limit?

If it appears you will exceed about $30,000 in repairs, see if any of your repairs qualify for the Energy Efficient Mortgage (EEM) program. If so, your lender may allow you to exceed the 203k limit in the amount of the EEM eligible costs, provided they are under the EEM limit, typically $8,000.

If your repairs do not qualify for EEM and your bid is over the 203k limit, you will have to remove repair items from your bid. You are not allowed to bring cash in at closing to pay for additional bid items out-of-pocket.

There is no minimum repair cost for a Streamline 203k. However, it may not be cost-effective to pay the extra 203k fees for just a few hundred dollars worth of repairs.

Check your FHA 203(k) eligibility. Start here (Sep 16th, 2024)

Working with a licensed contractor on a 203k loan

One of the most challenging aspects of a 203k loan is getting the contractor to work up a proper bid. Many contractors have never supplied a repair bid for the purposes of 203k financing, so they are often surprised at the requirements.

Before getting a bid for 203k work, make sure your contractor is willing to work and re-work the bid until it’s perfect. If your contractor seems wary, find another contractor. An incomplete bid can kill your 203k transaction.

A bid may not change nor can repair costs increase after loan closing. Make sure your contractor has supplied a solid bid and has not underbid the project in any way. It’s better to overestimate the bid. Any money not used for repairs is applied back to your loan principal after the work is complete.

What should a contractor’s bid include?

Here’s a list of items generally needed on the bid:

  • Contractor’s name, address, phone number, and current license number
  • Buyer’s name
  • Property address where the work is to be done
  • Permit costs, if any
  • Bid to state work will begin within 30 days of loan closing and all work will be done within six months of closing
  • Contractor’s acknowledgment that they will receive 50% of the repair funds at loan closing and the other 50% when all work is complete
  • Statement the buyer will not be displaced from the home for more than 30 days
  • Labor and materials must be broken out to separate line items on the bid
  • Tax must be broken out on the bid
  • The final bid amount must match the amount on the 203k Owner/Contractor agreement.
  • Buyer and Contractor signature and date

It’s best to have just one or two contractors on the job because you’ll need separate bids for each contractor. Getting all required documentation from multiple contractors can prove very time-consuming.

However, you will need additional contractors for electrical/plumbing/mold remediation if the general contractor is not specifically licensed in these areas. For instance, a general contractor who only has a contractor’s license cannot do even minor electrical work on a 203k project.

Download our Bid Checklist Spreadsheet Sample and Editable Spreadsheet to help you and your contractor(s) to understand the exact bid requirements and other documents needed. This spreadsheet is especially helpful if you have multiple contractors on your project.

What items do I need from the contractor?

In addition to a correct bid, here are some things your contractor may need to provide. Your lender may require more or less documentation depending on their guidelines.

  • Current license
  • Liability insurance, errors, and omissions insurance, and a bond
  • Contractor’s resume showing work experience
  • Workman’s comp insurance if the contractor has employees or hires subcontractors
  • Written business references stating the contractor is in good report with past clients
  • Contractor’s portion of the 203k Homeowner/Contractor agreement
  • IRS Form W9

Additional 203k forms to know about

In addition to the bid from a licensed contractor, you’ll need to acknowledge and sign these forms:

For editable versions of these documents, and more downloadable forms, see our Downloadable Mortgage Forms page.

Check your FHA 203(k) eligibility. Start here (Sep 16th, 2024)

Why do an FHA 203(k)? Is it worth the hassle?

By now you may be wondering – is all the red tape worth it?

If you’re willing to put in the extra time, this type of mortgage can offer some big advantages:

  • Home equity: Improving a home can increase its value, which means you can build home equity faster.
  • Less competition: Not everybody wants to go through the extra steps a rehab loan requires. That means you have fewer buyers to compete with.
  • Bargaining power: Sellers with homes in need of repair are often eager to sell, creating a “buyer’s market” atmosphere which can lead to lower prices. Sellers may be motivated enough to help pay some of the closing costs.
  • Low down payment: FHA loans, in general, require only 3.5% down for most borrowers. You could meet the down payment and pay closing costs — all for less than 10% upfront.

Each home and buyer is different. Some buyers, when they come across a fixer-upper, will need to pass and keep looking for a move-in ready home.

For other buyers, an FHA 203(k) loan is a smart way to turn a fixer-upper into their dream home.

How does a 203(k) loan work FAQs

What is a 203k loan?

An FHA 203k loan combines home buying and home renovating costs into one fixed-rate mortgage. Traditionally, buyers who needed to finance repairs to their new home would need a second loan after they closed on the first loan.

How does a 203k loan work?

A 203k loan provides funding to cover the price of the home and the cost of renovations. The money for repairs goes into escrow at closing.

How much do you have to put down on a 203k loan?

Most buyers can put 3.5% down. Down payment requirements are higher — at least 10% — for buyers whose credit scores fall below 580.

Is it hard to get a 203k loan?

A 203k loan requires some extra steps, like finding a licensed contractor who is willing to work with the FHA. The contractor must submit a repair plan and a budget prior to the loan closing. This process also requires some extra fees.

How long does it take to close on a 203k mortgage?

An FHA 203k loan may take six to eight weeks to close. After the loan closes, the contractor has six months to complete the approved renovations.

What can a 203k loan be used for?

A Limited 203k, also known as a Streamline 203k, can include up to $35,000 for renovations to the new home. Buyers can’t change the home’s structure, move walls, or add luxuries, but they can do cosmetic upgrades and improve home functionality. For a complete list of what’s possible, see the allowable and non-allowable projects section above.

Can I refinance and repair my existing home with a 203k?

Yes. The 203k refinance works just like the purchase program. This is a good idea for homeowners who don’t have enough home equity for cash-out refinancing. With a 203k, no cash will go to the borrower with a 203k refinance. All funds must go directly to the contractor doing the work and the current lender to pay off the existing mortgage.

Are 203k loans for first-time homebuyers?

Many first-time homebuyers will benefit from the FHA’s 203k loan program, but anyone who’s buying a primary residence can use this program.

What are some 203k loan alternatives?

Fannie Mae’s HomeStyle mortgage program resembles 203k. HomeStyle is a conventional loan. You’d need a credit score of at least 620 to qualify. Down payments on primary residences go as low as 3%. HomeStyle also works for second homes and vacation homes, but down payments and interest rates will be higher.

What is the 203k appraisal?

Almost all mortgage loans require an appraisal, but the 203k appraisal is different. The appraiser needs to know the home’s value after the planned repairs are complete. Your contractor’s bid will help the appraiser find the home’s future value. So be sure you have decided on all repairs and included them in the contractor’s bid. Changing your mind about repairs after the appraisal is complete may cause delays (and upset appraisers).

Can I do the work myself with an FHA 203k loan?

In some cases, this is allowed. Lenders might require documentation that you are qualified to do the work and can do it in a timely manner. Usually, this means you are licensed as a contractor or in a similar profession since it’s tough to otherwise document that you’ve had enough experience to do the job. If you can prove you’re qualified, you can only finance the cost of the materials, and you will still need to provide a detailed bid for the materials you plan to purchase.

Who qualifies for an FHA 203k?

Generally, most people who qualify for a standard FHA loan can qualify for a 203k loan, provided the 203k loan amount isn’t significantly higher than the buyer’s original pre-approval. The lender may charge a higher interest rate or higher fees for the 203k loan, so make sure with your loan professional that you still qualify.

Will a 203k loan finance a condo?

203k loans are for single-family homes, but they are allowed for condominiums as well. For condos, the work is allowed on the interior only, and no more than four other units in the condo complex can be undergoing 203k repairs at the same time.

Do I need a 203k consultant?

A 203k consultant is not required for a Streamline 203k. If you need a full 203k loan, you will hire a HUD-approved consultant.

Streamline 203k loan: The right fit for many buyers

Even though the 203k involves a few more leaps and hurdles than the standard FHA loan, it can be a great tool to buy a home that has potential. Don’t be scared away by the rules and requirements, because your lending professional should know the ins and outs of the 203k loan.

To be on the safe side, ask your loan officer how many 203k loans he or she has done in the past year, and how many the processing staff has done. Experience on the part of the lender can save a lot of time and headaches for the borrower. Find a loan officer who has done two or three of them in the past year, at least.

With a little help from your lender, and knowing what to expect, you can purchase a home and fix it up per your needs and wants. In a few short months, you could be in your fixed-up and touched-up dream home.

Check your FHA 203(k) eligibility. Start here (Sep 16th, 2024)

Tim Lucas

Editor

Tim Lucas (NMLS #118763 ) is an editor of MyMortgageInsider.com. He has appeared on Time.com, Realtor.com, Scotsman Guide, and more. You can connect with Tim on his website, ThisIsMortgage.com.