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How to use an FHA 203(k) loan to renovate a home
You’ve found a home in your dream neighborhood, and it’s for sale! The problem is — it’s been neglected for years and needs expensive updates and repairs.
Given the property's condition, you’re unsure if you’ll be able to get a mortgage to buy it. Unfortunately, you don’t have enough cash to purchase the home outright, let alone complete all the necessary renovations. An FHA 203(k) loan may be the answer. With this type of home loan, you can secure the financing you need to buy (and rehabilitate) your new home.
In this article:
What is an FHA 203(k) loan?
An FHA 203(k) loan is a type of FHA mortgage, which is insured by the Federal Housing Administration (FHA) that allows you to finance the home purchase and renovation with just one loan. Instead of taking out a mortgage to buy the home and a second loan to cover updates and repairs, you’ll get all the funding you need on one closing day.
If you qualify, part of the loan will immediately pay the seller for the residence. The remaining cash will be put into an escrow account to be disbursed as repairs are made to the property. The loan is FHA-insured before renovations are completed.
Standard vs. limited FHA 203(k) loans
You can choose between two kinds of FHA 203(k) loans: standard and limited. Here’s how they compare at a glance:
How to use an FHA 203(k) loan
Depending on your home’s needs and the type of FHA 203(k) loan you secure, you can use mortgage proceeds to do the following:
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Address health and safety issues
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Build or repair a garage
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Add rooms to the structure, including an attic or basement
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Repair the foundation or other structural elements
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Install or repair fencing, walkways, driveways, patios, decks, or porches
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Fix or install roofing, siding, gutters, or downspouts
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Repair, replace, or upgrade electrical or plumbing system components
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Repair or remove an in-ground swimming pool
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Make the home accessible to those with disabilities
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Rebuild a demolished home (if the original foundation is intact and usable)
The above list isn’t exhaustive. Generally, most renovations intended to increase the safety and functionality of the home would be deemed acceptable. However, you can’t use this loan for luxury upgrades like installing a new swimming pool or tennis court.
FHA 203(k) loan requirements
Property guidelines
You can use an FHA 203(k) loan to purchase and renovate the following types of properties:
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Two-to-four-unit townhouses
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Some condominiums (interior renovations only)
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HUD homes
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Manufactured homes titled as real estate (no structural repairs)
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Mixed-used properties (at least 51% must be residential)
Read more: 12 types of homes for buyers and renters
Borrowing limits
The FHA has loan limits that cap the amount you can borrow. The limit depends on your property type, value, and location. For instance, you can borrow up to $498,257 for a one-unit property in a low-cost area or $2,211,600 for a four-unit building in a high-cost area. (You may qualify for even higher limits if you live in Alaska, Hawaii, Guam, or the U.S. Virgin Islands.)
Once repairs are complete, you must get an FHA appraisal to determine the after-improved value.
Borrower guidelines
The FHA requires a credit score of at least 500 to qualify for a 203(k) loan, but your lender’s criteria may be more strict. In addition, mortgage lenders generally want to see a debt-to-income ratio (DTI) — how much you owe monthly relative to how much you earn — of 43% or lower.
If your credit score is 580 or higher, you can put down as little as 3.5% of the loan amount. However, if your score is 500 to 579, you must increase your down payment to 10%.
Learn more: The best FHA loan lenders
How do FHA 203(k) loans work?
An FHA 203(k) mortgage loan can have up to a 30-year term. You can also opt for a fixed or adjustable interest rate.
“Interest rates are slightly higher than regular FHA loans due to the higher propensity for risk,” Tiana Uribe, real estate broker at TRU Financial Services, Inc., said via email.
Your loan can also include extra funds for unexpected costs (known as “contingency reserves”) and mortgage payments. Your contingency reserve can be up to 20% of your projected repair costs. Your mortgage payment reserve can cover up to six months of home loan bills if you can’t live in the house during renovation.
Like any other mortgage, expect to pay closing costs. For instance, you’ll be charged an origination fee of up to $350 or 1.5% of the base loan amount, whichever is greater.
You should also be prepared to pay an up-front mortgage insurance premium (MIP) of 1.75% of your initial loan balance. You’ll also pay an annual mortgage insurance premium (billed monthly) must be paid on an ongoing basis — generally for the life of the loan.
Property rehabilitation must start within 30 days of closing and be completed within six months. However, if you’re current on your mortgage payments or your loan is in forbearance, you may be able to request an extension if the project runs long.
“The money [in escrow] for repairs will be given out in draws — an initial draw at closing and then additional draws throughout the process as the work is completed and signed off on by the HUD consultant,” said Ralph DiBugnara, founder of Home Qualified.
Pros and cons of the FHA 203(k) loan
All financial products have perks and pitfalls. Here’s how the FHA 203(k) loan stacks up:
Pros
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You can finance the purchase and renovation of the home with one loan.
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The mortgage typically has a lower interest rate than a credit card or unsecured personal loan.
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The renovations help you build equity quickly.
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The loan is relatively easy to qualify for.
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You can put down as little as 3.5%.
Cons
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The process can be long and complicated. (It takes longer to close on this type of loan than a regular FHA mortgage.)
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You may have to live in a construction zone for an extended period.
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Renovations must be HUD-approved, which can limit your options.
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You must pay for FHA mortgage insurance.
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The loan isn’t designed for real estate investors.
Should you get an FHA 203(k) loan?
“We are in a real estate market that overall has very little inventory,” said DiBugnara. “A large percentage of homes that are on the market are old and in need of at least [some] TLC. Most buyers are compromising because of high prices and bidding wars on homes that aren't ideal for their needs. A 203(k) loan is a great way for a borrower to buy a house that needs repairs and make it into their own.”
On the other hand, if the complexity and length of the process make you nervous, buying a fixer-upper with an FHA 203(k) loan may not be your best bet. You may also want to consider other types of renovation loans if you want to finance a new swimming pool or other luxurious upgrades that aren’t covered by 203(k) loans.
Dig deeper: When will the housing market crash again?
Alternatives to the FHA 203(k) loan
If the FHA 203(k) rehab loan isn’t right for you, several other financial products can help you upgrade your home.
Conventional renovation loans
Fannie Mae and Freddie Mac offer the HomeStyle Renovation and CHOICERenovation loan, respectively. The programs are similar in several ways. For example, both permit down payments as low as 3% for single-family residences. However, you should compare these options side by side and talk to your lender to determine which one would work best for you.
Home equity products
If your fixer-upper just needs cosmetic updates and you can live with the popcorn ceilings and wood paneling for a while, you could eventually tap into your home’s equity to pay for modernization. Your home’s equity is a measure of how much your property is worth minus what you owe on your mortgage, expressed as a percentage. For example, if your house is worth $500,000 and you still owe $300,000 on your mortgage, you have 40% equity.
Generally, you need 15% to 20% equity to qualify for a home equity product. It could take years to reach that milestone, depending on how large a down payment you made at loan closing.
Once you do, you could take out a home equity loan (which gives you a lump sum with a fixed interest rate) or a home equity line of credit (HELOC), which functions like a credit card and typically has a variable interest rate. You might also opt for cash-out refinancing, which involves obtaining a new mortgage large enough to pay off your first home loan and put money for renovations in your pocket.
FHA 203(k) loan FAQs
Can you refinance a home with an FHA 203(k) loan?
Yes, homeowners can refinance a home with an FHA 203(k) loan. However, while you can change your interest rate or loan term, Uribe said you won’t be able to tap your equity and take cash out.
Can I use an FHA 203(k) loan for a new home?
Although you can use an FHA 203(k) loan to buy an existing home that needs upgrades, you cannot use an FHA 203(k) loan to finance the construction of a new home. The mortgage is designed to help borrowers repair and upgrade homes that are at least one year old.
Can you buy furniture with an FHA 203(k) loan?
You can’t buy furniture with an FHA 203(k) loan. FHA-approved purchases and projects must be directly connected to the house and improve the functionality of that particular dwelling.
This article was edited by Laura Grace Tarpley.
