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How an FHA 203(k) Loan Works and Loan Requirements

How an FHA 203(k) Loan Works and Loan Requirements

  • Important FHA 203(k) Loan Considerations
  • Pros Cons
    • Finance a home purchase or refinance plus major home improvements with one loan instead multiple loans
    • Using a single loan save borrowers money and time
    • Loan amount based on as-completed property value
    • Low down payment / high loan-to-value (LTV) ratio
    • Lower interest rate than other home improvement mortgage programs
    • Applies to both home purchases and refinancings
    • Added upfront and ongoing cost of FHA mortgage insurance premium (MIP)
    • Extra closing costs and fees
    • Longer mortgage closing process timeline
    • Requires significantly more documentation than a standard mortgage
    • FHA loan limits
  • FHA 203(k) Home Loan Program Overview
  • The FHA 203(k) Loan Program enables home buyers or owners to finance the purchase or refinancing of a home plus the cost of a major home rehabilitation, improvement or remodeling project with a single FHA loan. Typically borrowers seeking to finance a major home improvement project are required to obtain a separate construction or home equity loan which can be expensive and time-consuming. Using a single loan instead of two separate loans simplifies the home improvement financing process, saving you money and time. The program can be used for significant home renovation projects or a total tear-down, making it an ideal financing option you are looking to buy or refinance a fixer upper.

    Another important benefit of an FHA 203(k) Loan is that the loan-to-value (LTV) ratio is based on the as-completed, post renovation value of the property.  Using a higher property value to determine the LTV ratio enables borrowers to qualify for a larger mortgage amount.  For example, let's use a case where the pre-renovation value of a property is $100,000 and the post-renovation value of the property is $125,000, after upgrades.  Applying a 95% LTV ratio means the borrower qualifies for a $95,000 loan ($100,000 * 95% = $95,000) based on the pre-renovation property value and a $118,750 loan ($125,000 * 95% = $118,750) based on the post-renovation property value.  While many mortgage programs calculate the LTV ratio based on the pre-renovation value of a property, an FHA 203(k) Loan uses the post-renovation property value which means borrowers qualify for a higher mortgage amount.

  • How an FHA 203(k) Loan Works
  • The process to apply for the program is different that for a standard mortgage or even a regular FHA loan. Below we outline the steps you should take to qualify for an FHA 203(k) Loan.

    Find a Property and Draft a Work Write-Up

    The first step in using the FHA 203(k) program is to identify the property you want to buy or refinance.  The next step is to work with a certified contractor to prepare a comprehensive work write-up of the home improvements you intend to make.  The project write-up includes a detailed description of the property improvements as well as the estimated cost for the improvements including an itemized breakdown of labor and material costs.  It is important to work with a certified contractor as both the lender and HUD are required to approve the contractor and any work contracts before the project begins.

    Select an FHA 203(k) Lender

    The next step is to find a lender with experience processing FHA 203(k) loans. The program is offered through approved lenders such as banks, mortgage banks, mortgage brokers and credit unions. Loans can be more challenging to process and close so it is important to select a lender that understands how the process works.

    The table below compares interest rates and fees for leading FHA lenders in your area. Contact multiple lenders to determine if they offer the FHA 203(k) program and request loan proposals. Like with all mortgages, we recommend that you shop at least five lenders to find the right combination of mortgage experience and competitive loan terms.

  • Current FHA Mortgage Rates as of November 21, 2018
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  • Submit Your Loan Application

    After you select a lender, the next step is to submit a loan application including the work write-up prepared by the contractor.  The lender reviews the write-up and your application including your personal and financial information to determine if you qualify for the loan and are eligible for the FHA 203(k) Program.  Additionally, as part of the application process the lender reviews the property appraisal to determine if the post-renovation property value supports the mortgage amount you are seeking.  A HUD inspector or consultant also review the property to determine if it is eligible for the program and provides a detailed cost estimate of the labor and materials required for the proposed home improvements.  The lenders uses the higher of the project cost estimates provided by the HUD inspector and borrower to determine the loan amount.

    Mortgage Closes and Home Improvement Funds Released to Escrow Account

    Assuming you qualify for the mortgage and the property appraisal and HUD inspections do not raise any issues, your loan application is approved and eventually your mortgage closes and funds. For a home purchase, when an FHA 203(k) loan closes the property seller receives his or her money, closing costs are paid to third parties and the remaining funds allocated to property improvements are placed in an escrow account.  For a refinance, your existing mortgage balance is paid in full, closing costs are paid and the remaining proceeds are placed the escrow account for property improvements.  Funds are released from the escrow account to pay for home improvements as they are completed.  A HUD inspector must verify that work has been completed properly before the lender releases funds from the escrow account.  Borrowers have six months from the date the mortgage closes to complete the home improvement project. 

    Contingency Reserve  Requirement

    Depending on the age and condition of the property and the nature of the home improvements, borrowers may be required to include a contingency reserve as part of their loan amount.  The contingency reserve is included in the escrow account to cover any cost overruns or unexpected expenses that are common with major home improvement projects.  A contingency reserve is required for properties with: 1) termite damage, 2) disconnected utilities and 3) properties older than 30 years.  Your lender or HUD inspector may also require a contingency reserve for more complicated or extensive renovation projects even if the property does not meet the three criteria outlined above.  The contingency reserve requirement ranges from 10% to 20% of the total renovation project cost and in practice most FHA 203(k) loans include a 15% contingency reserve.  Any leftover funds from the contingency reserve are applied to the mortgage balance unless borrowers fund the reserve with their own funds instead of from loan proceeds.

    Mortgage Payment Reserve Funds

    If borrowers cannot occupy their home due to the renovations they can include up to six months of monthly payments, including property tax and homeowners insurance (PITI), in the FHA 203(k) loan amount.  This mortgage payment reserve assists borrowers who need to pay rent to live in another property while work is being done on their home.  The number of payments included in the reserve must match the length of the work schedule submitted by the borrower and all monthly payments are made directly to the lender from the escrow account.  Any remaining mortgage payment reserve funds are applied to the mortgage balance.

    Home Improvement Project Completed

    When the home improvement project is completed, the HUD inspector performs a final inspection verifying that all work has been completed properly.  Additionally, the lender may order a second appraisal report to confirm the post-renovation value of the property.  After receiving the final inspection report the lender releases the remaining funds from the escrow account.  The funds are used to pay any outstanding contractor invoices as well as inspection and other third party fees.  Any remaining funds in the escrow account are applied to the mortgage balance and the escrow account is closed. 

  • FHA 203(k) Loan Requirements
  • As-Completed Property Value

    The FHA 203(k) Loans use the as-completed property value to determine what size mortgage you qualify for, which is a significant benefit to borrowers.  Lenders typically do not provide a mortgage based on the post-renovation value of a property which means that borrowers qualify for a smaller mortgage and are required to arrange a separate loan to finance home improvement projects.  Using the higher as-completed property value enables borrowers to qualify for a larger mortgage and eliminates the need to obtain a separate  construction or home equity loan.  According to program guidelines, for a home purchase, the property value is the lesser of:

    • the value of the property before the remodeling or rehabilitation project plus the cost of the project; or,
    • 110% of the appraised value of the property after the remodeling or rehabilitation project

    For example, if you are planning to make $50,000 in home improvements to a property with a pre-improvement value of $100,000 and a post improvement value of $150,000, the property value used by the lender to determine your FHA 203(k) loan amount is $150,000.  The pre-improvement property value ($100,000) plus the value of the improvements ($50,000) is $150,000 which is less than 110% of the appraised as-completed property value (110% * $150,000 = $165,000).   

    Maximum Loan-to-Value (LTV) Ratio

    The maximum loan-to-value (LTV) ratio for an FHA 203(k) Loan to purchase a home is 96.5% and the maximum LTV ratio for a refinance is 97.75%.  This means borrowers are required to make a minimum down payment of 3.5% of the as-completed property value for a purchase or have at least 2.25% equity in the property for a refinance.  For example, for a property with an as-completed value of $150,000 the borrower is required to make a down payment of $5,250 (3.5% * $150,000 = $5,250) or have $3,375 (2.35% * $150,000 = $3,375) in home equity for a refinance.

    Loan Limits

    Your FHA 203(k) mortgage amount cannot exceed the loan limit for the county in which the property is located.  FHA loan limits vary by county and by the number of units in the property being financed. In the contiguous United States, the FHA loan limit for a single unit property such as a home or condominium ranges from $294,515 to $679,650 for high cost areas and the limit for a four unit property ranges from $566,425 to $1,307,175.  In Alaska, Hawaii, Guam and the U.S. Virgin Islands FHA loan limits range from $1,019,475 for a single unit property to $1,960,750 for a four unit property.  In some cases borrowers who are installing a solar energy system may be eligible for a higher loan amount.  Additionally, borrowers can request a waiver of the loan limit for properties located in community revitalization or redevelopment zones.  All loan limit waivers must be approved by HUD.

    Use our free mortgage quote form to compare loan proposals from top-rated FHA lenders. Our quote feature is personalized, easy-to-use and does not affect your credit. Shopping for your mortgage enables you to find best loan terms including the lowest interest rate and closing costs.

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  • Property Eligibility Requirements
  • The FHA 203(k) Home Loan Program only applies to owner occupied properties.  You can use the program to purchase properties with up to four units, but at least one of the units needs to be owner occupied, or lived in by the individual(s) who obtained the loan to purchase the property. Investment properties as well as second and vacation homes are not eligible for the program.  Additionally, the property being financed must be at least one year old and meet certain energy efficiency standards.

  • Permitted Home Improvement Projects
  • The program applies guidelines to the scope and type of home improvement projects a borrower can finance.  The cost of the renovation project must be greater than or equal to $5,000.  The project can range from small to reconstruction.  The home can be demolished or razed as part of the renovation project as long as the existing foundation remains in place.  The program covers the rehabilitation of the residential portion of a mixed use property that also has non-residential uses. The program also covers the conversion of a property of any size to a one-to-four unit residential structure.  Please note that a limited amount of borrower sweat equity is permitted by the FHA 203(k) Program but all work must be performed by qualified contractors.  Borrowers are not allowed to use relatives or employers as their contractor.

    Home improvement, remodeling or rehabilitation projects covered under the FHA 203(k) Home Loan Program include:

    • structural alterations and reconstruction
    • modernization and improvements to the home's function
    • elimination of health and safety hazards
    • changes that improve appearance and eliminate obsolescence
    • reconditioning or replacing plumbing; installing a well and/or septic system
    • adding or replacing roofing, gutters, and downspouts
    • adding or replacing floors and/or floor treatments
    • major landscape work and site improvements
    • making energy conservation improvements
    • enhancing accessibility for a disabled person
    • installing a solar energy system
  • Borrower Qualification Requirements
  • Credit Score

    For a home purchases, the FHA 203(k) Home Loan Program typically requires that borrowers have a minimum credit score of 580 if you make a 3.5% down payment and a minimum credit score of only 500 if you make a down payment of at least 10%.  For refinances, the program typically requires a minimum credit score of 580 if you have 2.25% equity in your property and a credit score of only 500 if you have at least 10% equity in your home.  The equity in your home is determined by the loan-to-value (LTV) ratio calculated by the lender.  The minimum credit score required to qualify for an FHA 203(k) loan is lower than for most other home renovation mortgage programs, which means more credit-challenged borrowers are eligible for the program.  We recommend that you review your credit score six months to a year before you start the mortgage process to address potential issues.  Please note that some lenders may apply their own minimum credit score requirement that is higher than the FHA 203(k) Program guideline so be sure to check with your lender to determine their mortgage eligibility requirements.

    Borrower Debt-to-Income Ratio

    To qualify for an FHA 203(k) loan borrowers must typically have a maximum debt-to-income ratio of 43%, although it is possible to qualify with a debt-to-income ratio up to 50% or higher under certain circumstances . The debt-to-income ratio represents the maximum acceptable percentage of a borrower's monthly gross income that can be spent on total monthly housing expense plus payments for other monthly debts such as credit card, auto and student loans. Total monthly housing expense includes your monthly mortgage payment plus other housing-related expenses such as property tax, homeowners insurance and FHA mortgage insurance premium (MIP) as well as other potentially applicable expenses such as homeowners association (HOA) fees.

    Circumstances under which it is possible to get approved for a loan with a higher debt-to-income ratio of 50% include borrowers: 1) with a minimum credit score of 640, 2) making a down payment of at least 10%, 3) with supplemental sources of income that may not be reflected on their loan application, 4) whose monthly housing expense does not increase by more than 25% with the 203(k) loan and 5) with significant residual income.  Please note that being approved for a mortgage with a higher debt-to-income ratio requires extra work by the lender to document the borrower's compensating factors.

    First-Time and Repeat Home Buyers

    The FHA 203(k) Home Loan Program is available to both first-time and repeat home buyers.

    Use the FREEandCLEAR Lender Directory to find lenders that offer FHA 203(k)  mortgages as well as other home renovation loan programs.

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  • Program Costs and Fees
  • Mortgage Rate

    The mortgage rate for a FHA 203(k) loan is usually higher than the rate on a standard FHA or conventional loan but .125% -to .500% lower than other home improvement mortgage programs because the program is backed by the government. The interest rate is higher because of the additional work and risk involved with home improvement loans.  Borrowers should compare multiple lenders to find the FHA 203(k) Loan with the lowest rate and fees.

    Extra Costs

    Because the program involves significantly more work and documentation to process and close, borrowers are required to pay extra fees as compared to a regular mortgage.  In addition to standard mortgage closing costs, the program requires borrowers to pay a supplemental origination fee to the lender, a plan review fee, multiple HUD inspection fees, two appraisal report fees and a title update fee at the end of the project.  Borrower are also required to pay architecture, engineering, consulting and permit fees associated with the home improvement project although many of these expenses can be financed with the mortgage.  Please note that due to the additional documentation and review, FHA 203(k) loans can take three months or longer to process and close as compared to a regular mortgage which usually takes four-to-six weeks to close.

    FHA Mortgage Insurance Premium (MIP)

    FHA 203(k) Home Loan participants are required to pay an up-front and ongoing monthly FHA mortgage insurance premium (MIP).  FHA MIP pays for insurance that protects lenders in the event that borrowers default on their mortgage.  The up-front MIP  can be added to your loan amount while the ongoing monthly MIP is an extra cost on top of your mortgage payment.  The up-front FHA MIP for most loans is 1.75% of the mortgage amount while the ongoing MIP depends on the loan amount, loan-to-value (LTV) ratio and mortgage term. The MIP is discounted if the home meets certain energy efficiency requirements, which is applicable to borrowers who are looking to implement energy efficiency home upgrades.

  • Mortgage Program and Type
  • Mortgage Program

    30 year fixed rate mortgages and 5/1 adjustable rate mortgages (ARMs) are eligible for the program while interest only mortgages are not eligible.

    Mortgage Type

    The program applies to both home purchase loans and refinances.  Cash-out refinances are not permitted under the program although a limited amount of borrower sweat equity is permitted which may provide the opportunity for selected borrowers to take a small amount of cash out of their property.

    FHA 203(k) Streamline Program

    The FHA 203(k) Streamline Program permits borrowers to finance home improvement projects between $5,000 and $35,000 with a single FHA 203(k) loan. The FHA 203(k) Streamline Program requires less documentation and cost than the standard 203(k) Program but places limits on the cost and types of home improvement projects that can be implemented among other limitations.

  • Great Mortgage IdeaRelated FREEandCLEAR Resources

  • Sources

    FHA 203(k) Program Guidelines: https://www.hud.gov/program_offices/housing/sfh/203k/203k--df

About the author

Michael Jensen, Mortgage and Finance Guru

Michael is the co-founder of FREEandCLEAR. Michael possesses extensive knowledge about mortgages and finance and has been writing about mortgages for nearly a decade. His work has been featured in leading national and industry publications. More about Michael

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