Everyone recognizes FHA loans and their many benefits, but what many people do not realize is that the FHA also offers another program that is very beneficial for homeowners. FHA 203K loans are rehabilitation loans that combine with your purchase money or refinance money to give you the power to rehab your home without the need to have more than one loan or large amounts of cash. This FHA loan has the same easy to qualify for standards along with the backing of a strong agency, making it very easy for first-time homebuyers as well as subsequent homeowners to make the changes they want to a new or existing home.
What sets the 203K loan apart from any other loan is that the appraisal does not matter, in a sense. Yes, you need a value for the home, but things like structural issues or pests will not make your loan fail. Instead, the cost to make the changes to bring the home up to FHA code gets included in the loan amount so that the changes get made down the road and your home can pass a final appraisal when all of the work is complete. There are two types of 203K loans – the streamline loan and the standard 203K loan and they differ as follows:
- The streamlined 203K loan can only cover non-structural changes to your home and only allows for a maximum of $35,000 in changes.
- The full 203K loan does not have a maximum dollar amount and it can include structural changes. The lender will calculate the maximum loan amount based on your individual qualification factors, such as your income, debts, debt ratio, and the value of the home, both now and after completion of the work.
How to Use the FHA 203K Loan
There are several ways you can use the 203K loan to help you get the home you desire. The standard way is to purchase a home that needs renovations either to meet FHA code or to meet with your approval. The lender adds the cost of the desired or necessary changes to your loan amount after calculating the cost of the purchase of the home. There are other less common ways to use this loan as well, though:
- If you wish to move a home from one plot of land to another and make renovations, the 203K loan can help
- If you already own a home but wish to make significant changes, you can refinance into a 203K loan to finance the cost of the rehab into the loan
The one caveat this loan program has that others may not is that it must be your primary residence. Even if it is multiple unit property, you must occupy one of the units in order to qualify for the 203K loan.
The standard 203K loan does not have a lot of limits when it comes to making changes to your home; you can include any structural changes to your home. In addition to structural changes, here are some of the most common things people do with this loan:
- Modernize the home
- Bring the home up to code with the FHA as well as the city/county
- Change or update electrical or plumbing systems
- Repair or replace the roofing
- Make a home accessible
- Make energy efficient changes
- Make cosmetic changes, such as new carpeting or hardwood flooring
- Change paint colors
- Add additions
- Add exterior additions, such as a 3-seasons room, porch, or patio
These are just a sample of the changes you can make to your home. The full 203K loan does not restrict your changes; the only requirement standing in your way is the value of the home after the desired changes, which the appraiser figures out based on the current value and the value of the changes you plan to make.
Figuring out a Loan Size
Figuring out the loan size of your 203K loan is the hardest part. You have to have all of your ducks in a row when preparing for this type of loan in order to ensure that you cover everything. As a general rule, your final loan amount cannot exceed 110 percent of the future value. The appraiser is the person to figure out the future value, which means you have to figure out the changes you want to make and get cost estimates before anyone can determine a loan size. In addition to these requirements, you have to abide by the FHA loan maximums for your area. Each county has a median home price that determines the FHA maximum loan amount. In low-cost areas, the maximum FHA loan amount is $271,050 and the highest is $625,500. These are the highest and lowest numbers, however, generally, the maximum loan amount falls somewhere in between these numbers.
203K loans have the same credit requirements as standard FHA loans. You cannot have a credit score lower than 580 in order to qualify, according to the FHA, but some lenders require an even higher score for their own peace of mind. In addition, the following requirements pertain to both FHA and 203K mortgages:
- Generally, you must bring all late payments current before you close on your 203K loan. Some lenders allow a few collections to slide, but if they are federal or state debts, you must pay them first. The only exception to the rule on collections is if you arranged for a payment plan with the creditor and have written proof of the plan.
- If you have a Chapter 7 bankruptcy reporting on your credit report, you have to wait 2 years from the discharge date to apply for a 203K loan.
- If you have a Chapter 13 bankruptcy reporting on your credit report, the lender needs to see that you make regular payments (on time) with the trustee. You also need the approval of the trustee to add another debt to your financial profile.
- If you have a foreclosure reporting on your credit report, you must wait 3 years until you apply for a 203K loan.
- If you do not have any credit reporting because you have never owned a house and do not have credit cards or a car payment, you can use alternative credit lines, such as utility bills, rent payments, or insurance payments to qualify. You have to provide proof that you made the payments on time over a period of 12 months, in order to qualify in most cases.
Debt Ratio Requirements
The general debt ratio guidelines for 203K loans are as follows:
- Front-end debt ratio cannot exceed 31 percent
- Back-end debt ratio cannot exceed 43 percent
These numbers have exceptions, just like FHA loans. The lender makes the final decision on what debt ratio is acceptable. Generally, the higher your credit score, the higher the debt ratio the lender allows because your high credit score shows you have financial responsibility. If you have a lower credit score, you do not show financial responsibility, which means you may have to hold closer to the FHA limits. Your compensating factors, which are your liquid assets, job stability, and credit scores, can help your case if you have higher than average debt ratios. If you feel as if you have a special circumstance that is a one-time occurrence, such as an illness that prevented you from working and paying your bills on time, the lender might be able to grant an exception if you show financial responsibility before and after that occurrence.
Figuring it all Out
203K loans can cause a lot of confusion because they are not your standard loan with one loan amount; they are a loan that handles two aspects of the homeownership process. In order to make it easier, the FHA requires the use of a loan consultant on every 203K loan. This person’s job is to help you through the loan process. The consultant not only helps you determine the right loan amount but also helps to negotiate all costs with the contractors; goes over the contracts to ensure they are fair to everyone involved; and helps you determine what changes to make in the home. The consultant has extensive experience with 203K loans, so he knows what will and will not get accepted and he also has a general idea of how certain changes affect the value of a home. You can use the loan consultant as much or as little as you desire – some people use him right from the start when they select a home while others wait until the contractor selection and cost decision process are underway. In the end, the consultant handles all paperwork and back-and-forth between you, the contractors, and the lender to make sure everyone is on the same page. Last, but not least, the consultant handles the fund disbursement during the loan process.
The Contractor Selection
All work completed on your home requires the expertise of a contractor if you include it in your loan. The only way you can perform your own work is if you possess the skills necessary and can prove it to the lender. Even in a case like this, the lender has to approve your abilities before you can include the costs of your loan. If you do perform your own work, you must supply your own tools; you cannot use loan proceeds to purchase tools.
Selecting a contractor requires many steps, of which the loan consultant can handle all of them for you to simplify the process. When choosing a contractor, the professionals must supply the following items:
- Estimate of all work
- References for each contractor with contact information
- Proof of experience necessary to complete the job
All work needs to be in writing so that the loan consultant, lender, and appraiser can work together to determine if it will fit into your loan parameters. The more detailed the write-up, the more likely it is that you can include the costs of your loan. The lender only creates one escrow account, which means once your loan funds, you cannot make any more changes. The more specific you are in the write-ups and the costs that go along with them, the more likely it is that all changes will get included.
Once your lender approves the work and you choose the contractor, he must agree to the terms before you can close on the loan. This means he must agree on all pricing and the completion dates. Generally, you have 6 months to get all work completed on 203k loans and work must commence within 30 days after the closing.
Another function the loan consultant handles are the fund disbursement. This is done at equal intervals throughout the process. The first disbursement is the funds to pay for the purchase of the home or to pay off your existing loan if you refinanced your loan into a 203K loan. The remaining funds go into an escrow account. If the contractor requested funds up front in order to get the job started, the consultant can release those funds, but any money not requested up front and approved goes into the escrow account. This escrow account remains in place until the consultant approves the work. The closing paperwork will contain the frequency of approvals and disbursement of funds and must be followed.
In general, the consultant disburses the funds upfront and then again after the final inspection. The lender will not release funds until there is proof that there are no liens on the home from the contractors or any sub-contractors used on the job. Every escrow account includes 10 percent of the cost of the work as a safety measure. If you did not need to spend those funds for unforeseen circumstances, you can either use the funds for cosmetic changes that do not need approval or you can pay it back towards the principal of your 203K loan.
Justin McHood is America's Mortgage Commentator and has been providing expert mortgage analysis for over 10 years.