What is an FHA 203k Loan?
If you’re thinking of taking out a mortgage to finance a house, here’s what you should know about the 203k loan.
August 13, 2021
You’ve finally found your dream home in that select location, but there’s a catch: The house could use more than a few repairs to transform it into your little paradise.
It’s challenging to find adequate financing for a home that needs repairs or what realtors call ‘Tender Loving Care (TLC).’
Most mortgages will only finance the property value, leaving you to self-finance your renovations or apply for another mortgage. That’s why an FHA (Federal Housing Administration) 203k rehab loan is handy.
An FHA 203k loan covers both the proposed home value and the cost of renovation.
However, a 203k loan is not without its limitations. If you’re thinking of taking out a mortgage to finance a house, here’s what you should know about the 203k loan.
What is an FHA 203k loan?
An FHA 203k is a mortgage that is insured by the government. 203k loans target low to medium-level income borrowers with below-average credit scores (at least 500.) Since 203k loans are insured, they are less risky for lenders and tend to have lower interest rates than conventional loans.
As a 203k loan borrower, you only need a down payment that is equal to 3.5% of the property value, compared to 20% for a conventional loan. The amount of an FHA loan, however, is subject to regional/county loan limits that are as follows:
2021 FHA loan limits for low-cost areas. Image: fha.com
2021 FHA lending limits for high-cost areas. Image: fha.com
FHA 203k loan requirements for 2021
Some of the FHA 203k loan qualifications you need to meet are:
A down payment of 3.5% of the property value if you have a credit score of at least 580.
For a credit score of between 500 and 579, you’ll need a down payment equal to 10% of the property value.
If you’ve claimed bankruptcy, at least two years have to have passed since you were declared bankrupt (unless the cause of bankruptcy was beyond your control).
Up-to-date payments of your federal student loan and income tax.
At least two years of stable employment.
You have waited for at least three years before applying for a 203k loan if you’ve previously gone through mortgage foreclosure.
Proof of at least two years of successful self-employment if you are self-employed. Regular tax returns, your balance sheet, and cash flow statements come in handy. If you have been self-employed for less than two years, but more than one year, you have a solid income history for the preceding two years.
The percentage of your mortgage payments to your gross income is less than 31% (or 40% for some lenders.)
The percentage of your overall consumer debt to your gross income is lower than 43% (or 50% for some lenders.)
The property meets the Department of Housing and Urban Development’s (HUD) minimum safety and health standards.
How does a 203k loan work?
You can apply for a 203k loan for a term of either 15 or 30 years. Here’s what the 203k loan process looks like:
1. Choose between two types of 203k loans
There are two types of 203k rehab loans — Full/regular 203k and limited/streamline 203k.
A full/regular 203k loan covers a property’s structural changes (walls, foundation, and anything that alters a home’s architectural structure). It has no maximum financing limit.
A limited 203k loan covers non-structural changes to the property, up to a maximum of $35,000.
You also choose one of the two types of interest rate arrangements: Fixed- and adjustable-rate mortgages.
2. Select an FHA-approved 203k loan lender
The FHA does not directly lend you money. You have to apply for the loan through an FHA-approved lender.
The loan approval process looks like this:
The lender pre-approves you based on set criteria and determines that the property qualifies for a 203k loan.
You create a rehab proposal/repair bid detailing all the planned repairs and related costs, then present the bid to the lender.
The lender uses the information to determine the ‘as-repaired’ 203k appraisal—an estimate of the property’s fair market value after repairs.
Using the home value estimate, the lender calculates your loan and underwrites it.
3. Settle FHA 203k closing costs
You must close or settle your loan before you can own your home, receive your loan, and start paying your mortgage. Some common settlement costs are escrow fees, homeowners insurance, and property taxes.
FHA closing costs average 2% to 6% of the property value. You can roll these costs into your loan, however. The FHA also allows sellers to contribute up to 6% of the property value to cover some closing costs.
4. Start repaying your loan
Your down payment of 3.5% or 10% of the property value (depending on your credit score) needs to be put down in full. You cannot roll a down payment into your mortgage loan.
FHA gift fund guidelines permit sourcing 100% of your 203k down payment from gifts or money assistance programs.
You’ll also pay your monthly mortgage consisting of mortgage insurance premiums (MIP) and the 203k loan.
Some of the loan funds go into an escrow account for repair costs to contractors. The FHA also keeps your MIPs in an escrow account and pays the lender in case you default.
Mortgage insurance includes:
An upfront MIP of 1.75% of the loan amount,
which you can pay as part of the closing costs or roll them into your loan.
An annual MIP of between 0.45% to 1.05% of the loan amount
, divided into monthly payments.
The premiums are higher for larger loans, longer loan terms, and smaller down payments. The payment period is either 11 years or your entire loan term. Here is how the FHA determines the insurance payment period:
FHA criteria for Mortgage Insurance Payments (MIP). Image: fha.com
Pros and cons of an FHA 203k loan
When you’re considering an FHA 203k loan, you’ll want to relate any pros and cons to your specific financial situation:
Pros
Requires a credit rating of at least 500.
You get property value financing plus the cost of repairs.
With a fixed-rate mortgage, you enjoy a fixed interest regardless of your credit rating or down payment amount.
Cons
You can only finance a personal residential property and not a rental or investment property.
If you have a credit score of less than 500, you cannot access a 203k loan.
MIPs increase your loan cost.
Loans are subject to county limits.
Should you get an FHA 203k loan?
Most homes that need TLC list for a much lower price to attract buyers. If you are a first-time homeowner with below-average credit and limited cash, an FHA 203k loan can help you grab that cheaper house and create more equity.
If at any point you cannot pay your mortgage due to financial difficulty, the FHA provides loan relief in the form of reduced minimum payments.
However, if you have a credit score of over 620 and can afford to make a larger down payment, a conventional loan might be a cheaper financing option.