Not that long ago, if a homebuyer wanted to buy a house that was in need of repairs or modernization, they would have had to undertake an arduous and expensive path to acquire home financing.
First, most banks would not have even considered granting a mortgage until the repairs had been made. But it would not have been possible to make the repairs until the home had been purchased. A classic catch-22 situation.
Second, even if the homebuyer could have cobbled together provisional acquisition and improvement loans, they usually came with onerous terms – higher interest rates, shorter repayment terms and a final balloon payment. This put potential homebuyers in a thorny spot.
Let’s say you found a house you’d like to buy but it’s in need of some repairs. The FHA 203(k) rehab loan allows you to finance the purchase price of your house and the cost of needed repairs – all in a single loan.
You no longer have to lose sleep wondering how you’re going to make the necessary repairs so the bank will grant you a mortgage. You no longer have to beat the bushes for a 2nd mortgage loan to finance the repairs. Finally, you no longer have live in a house that’s in disrepair until you can afford the improvements out of pocket.
An FHA 203(k) loan can take care of all of this – and more – in a single loan transaction.
As a result, the FHA 203(k) rehab loan has become a very popular choice among potential homebuyers who wish to purchase a home that is in need of renovation or repairs.
Qualifying for an FHA 203(k) Rehab Loan
The FHA 203(k) Rehab Loan is a loan program that is administered by the Federal Housing Administration (FHA), which itself is a division of the U.S. Department of Housing and Urban Development (HUD). The important thing to know about all FHA loans (including the 203(k) loan) is that the FHA does not make loans directly to the borrower. Rather, the FHA insures the loan that a borrower receives from an FHA-approved lender.
The FHA insurance is important to both lender and borrower alike. Because the lender is protected by insurance in case of borrower default, they can generally offer more generous and lenient loan terms, which obviously benefits the borrower. Plus, all FHA-insured loans were created to primarily assist first time homebuyers and so they permit lower credit scores (580+) and lower requirements for down payments (3.5%).
Generally speaking, the same requirements that a borrower must meet to be the recipient of any FHA-insured loan also applies to those borrowers who are seeking an FHA 203(k) rehab loan.
Here’s a list of the basic requirements for qualifying for an FHA-insured loan (as specified by the FHA):
• Minimum FICO score of 580
• Minimum down payment of 3.5% of the purchase price
• Steady employment history or worked for the same employer for the past two years
• Must have a valid social security number and lawful residency in the U.S.
• Must have a property appraisal from an FHA-approved appraiser
• Front-end ratio (mortgage payment plus HOA fees, property taxes, mortgage insurance, homeowners insurance) needs to be less than 31 percent of gross income
• Back-end ratio (mortgage plus all your monthly debt – i.e. credit card payment, car payment, student loans, etc.) needs to be less than 43 percent of gross income
• Must be two years out of bankruptcy and have re-established good credit.
• Must be three years out of foreclosure and have re-established good credit.
In addition to meeting the basic requirements that apply to all FHA-insured loans, an applicant for an FHA 203(k) home loan must also be willing to purchase a property that is in need of repairs or modernization, and then be willing to take the necessary steps to document and budget for those expenses, and abide by the rules for their payment and disbursement.
Types of 203(k) Rehab Loans
The FHA offers two types of 203(k) rehab loans – the Full 203(k) and the Streamline 203(k).
The Full 203(k) Rehab Loan is applicable when a house requires structural repairs. Structural changes are permitted with a Full 203(k) loan; in fact, the entire house can be leveled and rebuilt, as long as a portion of the existing foundation system remains in place.
In addition, there is no maximum repair limit with a Full 203(k) loan; however, the entire loan must be below the FHA’s maximum loan amount for the region.
The Streamline 203(k) Rehab Loan is the more popular loan type, and is likely to suit most potential homebuyers who are interested in purchasing a fixer-upper property. As a result, more lenders offer the Streamline 203(k) program.
The Streamline 203(k) Rehab Loan is perfect for a borrower who qualifies for an FHA loan, but wishes to buy a property that won’t qualify for FHA financing, as is. The Streamline 203(k) loan allows the borrower to secure a single loan that will finance the purchase price of the home, plus the cost of repairs.
However, it is important to note that the Streamline 203(k) loan has a ceiling in terms of the amount of money that can be financed for repairs – a maximum of $35,000.
How the 203(k) Rehab Loan Program Works
The following describes the typical process that a buyer would experience when pursuing a 203(k) Rehab Loan:
1. The buyer finds a home that is in need of repairs or modernization.
2. The buyer consults with a loan professional about a 203(k) loan.
3. Assuming the buyer is qualified, the lender issues a pre-approval based on the estimated purchase price and repair costs, plus other 203(k) fees.
4. A general contractor is hired to work up a detailed bid of all repairs.
5. An appraisal is ordered, which will reflect the future appraised value of the home.
6. The lender submits all relevant information to underwriting, and the underwriter issues an approval, usually with conditions that the buyer and the contractor must meet.
7. Once all conditions are met, a closing is scheduled and the buyer signs final loan documents. 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 up front. The other 50% will be paid to the contractor when all work is complete (the contractor has six months to complete the work).
9. When the work is complete, the remaining repair costs are issued to the contractor.
10. The buyer now has a home that is modern and up-to-date, and because of the repairs, there is also equity value in their home.
Note: After the final disbursement to the contractor, if there are any leftover funds, they will be applied to the principal balance of the loan.
Allowable/Non-Allowable Repairs with a Streamline 203(k) Loan
Most buyers are pleasantly surprised about all the types of repairs that are allowed with a Streamline 203(k) Rehab Loan. The program allows for all kinds of repairs – from the purely cosmetic to major essential improvements.
Streamline 203(k) funds can be used to remodel a kitchen or bathroom, adding new amenities or modern appliances. Or the funds can be used to facilitate major repairs, like replacing a roof or upgrading electrical and plumbing systems.
The one restriction with a Streamline 203(k) loan involves structural repairs. These funds cannot be used to alter the foundation or load-bearing walls, etc.
If you wish to purchase a home that is in need of structural repairs, then you must apply for a Full 203(k) Rehab Loan, which allows for these kinds of repairs.
Streamline 203(k) Allowable Repairs:
• Plumbing, Electrical & HVAC
• Roof (repaired or replaced)
• Mold remediation/termite damage
• Septic system/well repair
• Kitchen/bathroom remodels
• Appliance purchase and install
• Basement finishing/remodeling
• Asbestos removal
• Disability access improvements
• Lead-based paint stabilization
Streamline 203(k) Non-Allowable Repairs
The FHA has determined that some improvements are “luxury” items, or not permanently attached to the home, and therefore are not allowable under their guidelines:
• Swimming pools
• Hot tubs, saunas & spas
• Barbecue pits
• Outdoor fireplaces (indoor fireplaces are allowed)
• Tennis courts
• Satellite dishes
• Any alteration to improve commercial use of the property
203(k) Loan Rehab Fees
203(k) loans are a great option for purchasing a property that is in need of repair – one you intend to live in – but like most things in life, nothing is free. There are certain costs that are associated with this loan program that you should be aware of, and be prepared to pay, if you choose to participate in this program.
Mortgage Insurance – You will be required to carry standard FHA mortgage insurance, which is typically 1.75 percent of the full loan amount upfront (this can be rolled into your loan). In addition, you’ll also pay a small ongoing fee with each monthly payment. Typically, this is 0.85 percent of the loan amount yearly, but it is broken into 12 equal monthly payments.
By way of example, on a $250,000 loan, the cost of mortgage insurance would be $4,375 upfront and $177 per month.
Origination Fee – Your lender might also charge what they refer to as “a 'supplemental origination fee”, which is the greater of 1.5% of the loan amount or $350.
203(k) Loan Rates – Mortgage rates for FHA 203(k) Rehab loans are somewhat higher than they are for standard mortgage rates. Expect to receive a rate about 0.75 percent to 1.00 percent higher than for a standard FHA loan.
Closing Costs – Closing costs on a 203(k) loan average somewhere between 2%-5% based on the lender and your credit score. By way of example, a $200,000 loan will have closing costs somewhere between $2,000-$7,000.
Make sure to receive quotes from several 203(k)-approved lenders in order to get the best mortgage rate and the lowest closing costs.=
Refinance and Repair Your Home with a 203(k) Rehab Loan
The 203(k) loan program also is available to those borrowers who would like to make repairs to their home and are willing to refinance their mortgage to do so.
The 203(k) Refinance works exactly like the purchase program. However, in a refinance, the “purchase price” is essentially whatever the amount is to pay off the existing loan. Typically, the projected repair costs are then added to that amount to determine the total new loan amount.
One stipulation – no cash may go to the borrower with a 203(k) Refinance loan. All funds must go either to the contractor who has been selected to make the repairs and to the current lender to pay off the existing mortgage.
The FHA 203(k) Rehab Loan Program: Making Homeowners’ Dreams Possible
The FHA 203(k) Rehab Loan Program requires a bit more work than the standard FHA loan but in the end, it can be worth it. There’s a lot of paperwork involved and the decision-making process can be time-consuming. Plus, you have to have the patience and the extra time to oversee the repairs and to deal with the contractors.
But if you’re undaunted by the rules, regulations and requirements, then in a few short months, you could be living in your fixed-up dream home, once the repairs have been completed. Plus, it is entirely possible that you will have instant equity in your new home as well.
If the FHA 203(k) Rehab Loan Program seems like the right fit for you, then consult with an FHA 203(k)-approved lender and see what possibilities exist for you.