FHA 203K Construction Loan

So You Want To Buy A Fixer-Upper

Buying a home that needs some TLC can be a good choice. Imperfect homes come with less competition from other buyers, and you can build tens of thousands of dollars in additional equity in a short time by making relatively minor improvements.

But there’s a reason not as many people want to buy a fixer. It does take more work, planning, and time compared to buying your standard “turn-key” home.

Up for the challenge? Then rewards await. Here are your first steps.


What Is An FHA 203k Loan?

An FHA 203k loan, (sometimes called a Rehab Loan or FHA Construction loan) allows you to finance not one, but two major items 1) the house itself, and; 2) needed/wanted repairs. Because the lender tracks and verifies repairs, it is willing to approve a loan on a home it wouldn’t otherwise consider.

The loan addresses a common problem when buying a fixer home: lenders often don’t approve loans for homes in need of major repairs.

A home must meet certain safety and livability standards. Some home buyers are handy enough to buy the house and fix it up themselves. But, if the home is too run down, you can’t get a loan in the first place.

The 203k lets you buy and fix up a house in one transaction, allowing the lender to approve the loan despite its initial condition.


How Does It Work?

The process is like that of regular home buying, with some modifications:

Apply → Get Approved → Find A Contractor → Get Bids → Close the loan → Complete Repairs → Move in

Receiving a final approval involves lining up contractors and receiving bids, and some additional “hoops” to jump through. Don’t get stressed at this process, though. The 203k lender will drive the process and guide you through. You’re not on your own!

Choose your projects: The first step is deciding which repairs you want to do (see “What Kind of Repairs Can I Do?” below). The lender will require any safety or health hazards to be addressed first – things like mold, broken windows, lead-based paint, and missing handrails.

From there, choose which cosmetic items you want to take care of. For instance, say you want to replace appliances, add granite in the kitchen, and gut the bathroom. Those are all acceptable projects for the loan.

Choose your contractors: Once you’ve got your project list together, find contractors. The contractors must be licensed and insured, and typically have to be in full-time business. No buddies who do construction on the side, and you typically can’t do the work yourself unless you’re a contractor by profession.

Best results will come from super-experienced and professional remodeling firms that have done at least one 203k renovation in the past. Remember: your entire project can be held up by one contractor that is unwilling to complete the necessary forms. You might even go so far as to write the 203k paperwork requirements into the contractor agreement.

Get your bids: Once your contractor is “on board” with helping you complete your loan, get official bids. Make sure the bids aren’t “guesses”. They must be completely accurate. The reason is that the lender will submit final bids to the appraiser, who builds the value of the work into the future value of the property, upon which your loan is based.

Changing bid dollar amounts later could incur additional appraisal costs and trigger re-approval with the lender. Again, make sure your contractor knows all this!

Submit everything to the lender: By this point, the lender will have your income, asset, and credit report information. Once it has all the required bid paperwork, your loan can go to “final approval”.

Close the loan: You will sign final documents, and the house is officially yours.

The contractor starts work: Once the loan is finalized, the contractors can complete the work. Depending on the extent of the repairs, you may be able to move in at the same time.

For bigger projects, arrange to live somewhere else until work is complete. You can finance up to six months of payments for the new mortgage to allow room in your budget to do so.

Move In And Enjoy: The work is complete, and you’re the owner of a beautiful new home. You’ve probably built a ton of equity in a short time, and you didn’t have to engage in a bidding war to buy your ideal home.


Who Is Eligible?

A 203k is a sub-type of the popular FHA loan, which is built from the ground up to help those who might not otherwise qualify for a mortgage. FHA’s flexibility makes 203k qualification drastically easier than for a typical construction loan.

FICO: FHA allows credit scores down to 580, although some lenders might require a score of 620-640 to qualify for a 203k. Still, that’s much lower than the 720+ you would probably need for a conventional construction loan.

Down Payment: FHA requires just a 3.5% down payment, based on the purchase price + total project cost. For instance:

  • Home price $200,000
  • Total project cost: $25,000
  • Down payment: $7,875 (3.5% of $225,000)

You can receive 100% of your down payment requirement via a gift from family or approved non-profit organization.

Debt Payments and Income: Lenders will examine your debt-to-income ratio. This is the comparison of your income and debt payments. Typically, less than 43% of your income should go toward your proposed house payment plus all other debts.

That’s $430 in payments per $1,000 of before-tax income.

For example, if your income is $5,000 per month, your future house payment plus auto loan payments, student loan payments, and credit card bills shouldn’t exceed $2,150 per month.

Loan amount: You can borrow up to 110% of the property’s proposed future value, or the home price plus repair costs, whichever is less. These loans are also subject to your region’s FHA loan limits.

Occupancy: You must plan to live in the property you are buying. If you plan to fix and flip, the 203k loan isn’t for you.

Citizenship: All FHA loans are available to U.S. citizens and lawful permanent residents. Lenders will verify citizenship status at time of application.


What Repairs Can I Do?

There are two types of 203k loans. Which one you choose depends on the extent of the repair work.


203k streamline

This option allows you to do relatively minor repair work. Things like kitchens and bathrooms.

The stated limit to costs is $35,000. However, an FHA 203k loan requires a “buffer” equal to 15% of the total bids. This buffer is called a contingency. It’s a “just in case” fund to cover cost overruns by your contractor. (If the contingency fund is not used, it is credited back to you). So, your “real” maximum repair job can cost around $31,000.

Most non-structural, non-luxury items are acceptable:

  • Kitchen and bathroom remodels
  • Appliance replacement
  • Carpet and flooring
  • Roof replacement
  • Painting
  • Repairing safety and health issues
  • Energy-efficient improvements
  • And much more

In short, you can’t do anything structural (move load-bearing walls, add rooms) or change the footprint of the home.

So why choose the streamline 203k option? Because more lenders offer it than the full 203k. And, it’s a much simpler process than the standard option.


203k standard

With this option, you can do just about anything you want to the home, except non-permanent changes or adding luxury amenities.

  • Structural alterations
  • Convert a one-family home into a 2-, 3-, or 4-unit home, or vice versa
  • Connect to public sewer or water
  • Some larger landscaping projects
  • Improve accessibility for disabled persons
  • Move the house to a different site

Read More → Should You Choose A Standard Or Streamline 203k?

What you can’t do with the loan

  • Minor landscaping
  • Add a luxury amenity like a tennis court, barbecue area, or swimming pool
  • Projects that will take longer than 6 months

203k Loan Rates & Mortgage Insurance

Mortgage rates are somewhat higher for FHA 203k loans. Expect to receive a rate about 0.75% to 1.00% higher than for a standard FHA loan. Still, base FHA rates are some of the lowest on the market, so 203k rates are competitive.

You’ll pay standard FHA mortgage insurance, which is typically 1.75% of the full loan amount upfront (rolled into the loan) and 0.85% yearly (broken into 12 equal monthly payments). On a $250,000 loan, that’s $4,375 upfront and $177 per month.


Downsides

As you would expect, there are some plusses and minuses with the loan.

The benefits are undeniable: gain a ton of instant equity, experience less competition for the home, and gain valuable experience remodeling a home.

But with every reward comes the preliminary work. The 203k loan is no exception.

As stated above, you will have to secure reputable contractors, and be uber-diligent about having them complete paperwork. Don’t be surprised if the lender requires you to send a bid back to the contractor two or three times for missing information.

You will also have to decide on the upgrades that are within your budget. That can be exciting, but also stressful. You’ll have to make decisions quickly to ensure the loan approval stays on track.

The loan process will take more time than a standard loan. You are increasing paperwork requirements by 2-3 times compared to a standard loan. Go into the process expecting and embracing that fact. Don’t think that you’ll be the exception that closes the loan in fifteen days. Set realistic expectations with the seller!

Are you ready to tackle these relatively minor inconveniences to reap the benefits? Then a 203k loan is probably the right loan for you.