Money

What Is a 203(k) Loan?

If you’re looking to buy a home that needs a lot of work, you might be able to get it for a discounted price. The short- and long-term repair costs could still end up breaking your budget, however.

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That’s why a Federal Housing Administration 203(k) loan might be something to consider. It allows you to combine home purchase and renovation costs in one loan. After completing the renovations, you’ll have created instant equity based on the increased value.

Although there are fewer lenders that offer the government-backed loans because of the added oversight and paperwork, here is a look at how these loans operate and why it might be worth the extra legwork to find one.

What Types of 203(k) Loans Are There?

The loans, which are officially called 203(k) Rehab Mortgage Insurance, allow homebuyers to finance the cost of the purchase plus the renovations in one loan, or for homeowners to finance the rehabilitation of their current home.

The loans can be especially attractive to first-time homebuyers because the credit score and down payment requirements are more lenient than for most conventional loans. If you have a credit score of more than 580, you can finance up to 96.5% of the purchase and renovation. If your score is in between 500 and 579, your down payment would have to be at least 10%.

Also, if the home needs some work before the homebuyers can move in, the loan gives them a chance to “customize and personalize their home the way they want it,” says Brad Smith, director of specialized products at mortgage lender Guaranteed Rate.

There are two types of 203(k) loans:

Limited. The loan allows up to $35,000 in financing for nonstructural repairs and upgrades, and there is no minimum amount you have to borrow. The money can be used toward property repairs or to prepare the home for sale. Examples of upgrades would include a kitchen remodel or new carpeting. You won’t be able to do a major renovation with this loan.

Standard. A wider range of remodeling options is possible with this loan, including structural repairs. It requires a minimum loan of $5,000 for repairs. It also must involve a 203(k) consultant who will work with the lender and borrower. There is no specific dollar limit on the loan, but the combined home purchase and renovation loan cannot exceed the FHA mortgage limit for the area.

With a standard 203(k) loan, part of the loan goes to pay the home’s seller, and the rest is kept in an escrow account to pay for the repairs.

Steps Required to Get a 203(k) Loan

If you’re interested in a 203(k) loan, your first step will be to find a lender who offers one. Not every lender offers FHA loans, or, if it does, the lender might not provide the 203(k) option. Check the Department of Housing and Urban Development lender search, which will give you a list of all lenders who have offered a 203(k) in the last year.

You will work with the lender on the next few steps, as you review what needs to be renovated on the house and determine the size of the loan and scope of the project.

Inspections are vital for homes purchased with a 203(k) loan because you have to identify the necessary health and safety upgrades as well as other updates that you would like to make. You’ll need to bring on a HUD-certified inspector to ensure FHA standards are met.

“The ideal process is to include that HUD consultant to conduct the upfront inspection on the property to identify all the repair items,” Smith says.

A certified consultant’s duties include visiting the home, detailing the work that needs to be done and performing inspections.

The inspection is key to itemize all the home repairs needed because “you only have one chance to do it right,” Smith says. You can’t add money for additional repairs once the initial financing is done. If you have to reallocate project funds to pay for a health and safety issue identified once renovation has started, it could take away funds for something else, such as a bathroom upgrade, he adds.

Get an estimate and hire a contractor

Use the consultant’s report to get bids from contractors, Smith says. You’ll usually hire a general contractor who can work with as many subcontractors as needed to complete the work, or you can hire individual specialty contractors such as a roofer, plumber and electrician.

“You need to hire somebody who understands the type of renovations you’re looking to do and has done those in the past,” says Ron Haynie, senior vice president of mortgage finance policy for the Independent Community Bankers of America.

The type of work that could be done with a 203(k) loan includes:

  • Addressing health and safety issues
  • Putting on a new roof, gutters and downspouts, or adding to them
  • Replacing floors
  • Making structural changes or reconstructing parts of the house
  • Allowing for better access for a person with a disability
  • Improving energy conservation
  • Landscape work
  • Home modernization and appearance improvements

Once you have defined the scope of the renovations, the lender will hire an FHA-approved appraiser who will estimate the home value based on completion of all repairs and upgrades. The value will be either the property’s value before rehabilitation plus the cost of the renovation or 110% of the appraised value after the upgrade – whichever is less.

An appraisal that is much higher than the current value of the home indicates that the repairs will pay off for the homeowner. If you buy a home that needs a lot of work in a neighborhood that has excellent homes and make the necessary repairs, you can create some equity for yourself after closing, Smith says.

Once the value is set, the money reserved for the renovations is set up in the borrower’s name in a custodial bank, Smith says. Disbursements to the contractor are made as work is completed and inspected. The amount will also include a contingency reserve, which could be about 10%.

Reserve funds are vital in case more problems are found in the home.

“When you go into it, you’re thinking one thing,” Haynie says. “As the project progresses, it will change, and you need to be prepared for that. That might mean you need to have more reserves on hand.”

If the work on the home is so extensive that you can’t live in it during renovations, you’ll be able to finance up to six months of mortgage payments so you won’t have to pay for your current home and the new one at the same time, Haynie says.

Why Is a 203(k) Loan a Good Idea?

For homebuyers, a 203(k) loan can take care of two issues at the same time – buying a home, and planning and financing a renovation that would need to be done soon after moving in, if not right away.

In a tight housing market with a lot of aging homes, a 203(k) loan can broaden the type of homes that buyers can purchase. Otherwise, it’s tough for new homeowners – especially first-timers – to come up with the money to make repairs after they move in.

“Homeowners can get into trouble financing using credit cards and other means,” Smith says. It also could take longer to make the repairs and renovations you want in a home once you move in, he says. With a 203(k) loan, you can get them all done upfront.

Are There Other Options for Renovation Loans?

If you’re a first-time homebuyer, you might be caught up in visions of HGTV-like renovations for the home you plan to buy, but it could be overwhelming to move into your new home while dealing with a major reconstruction project.

“Anybody who does any kind of renovation in their home quickly realizes the project grows beyond what you thought it was going to be,” Haynie says. “When you start tearing down walls, you’re going to find all kinds of stuff that changes your original plan.”

One option some lenders would prefer to a 203(k) loan is a separate, dedicated construction loan to fund renovations. For example, community banks do a lot of construction lending and might keep the loan in their portfolio, which gives the borrower more flexibility, Haynie says. A separate construction loan also allows the homeowner to avoid FHA rules – which include the payment of home mortgage insurance during the loan. Because you won’t need to start renovations right away, you’ll get time in the home to figure out what you really want to change.

A standard refinancing is another option for homeowners who want to pay for a major renovation, rather than a 203(k) refinance. A bank could arrange a cash-out refinance with the homeowners and help them manage the process of paying for the project, Haynie says.

Homeowners who don’t want to refinance could:

  • Take out a home equity loan or get a home equity line of credit. If you have enough equity in your home, this could be an ideal option because of current low interest rates. The interest might also be tax-deductible.
  • Open a personal loan. The interest rates are generally higher on unsecured personal loans than home equity loans, but it’s a good option if you don’t have enough home equity but can handle the monthly payments.

Whether you’re a prospective or current homeowner, you might find a major renovation to be too expensive. With many homeowners deciding to expand their current homes to get extra space for offices and other needs, the price for workers and materials is going up, Haynie says. The best option might be to buy a home that has everything you want already.

“Look at all your options,” Haynie says. Ask yourself, “What is it I really need to get out of this renovation, and is it worth it?”

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