How FHA 203(K) Rehab Home Loans Work
If you want to buy a home with an affordable price tag, you may want to look at a home that needs renovations or repairs. If you are on a tight home-buying budget, you should consider a mortgage where the lender finances both the price of the home and the cost to fix up the house. The most prominent of these mortgages is the 203(k) home loan offered by the Federal Housing Administration. Here is a guide to walk you through how these loans work.
How FHA 203(k) Rehab Loans Work
Often referred to as a construction loan or rehab loan, an FHA 203(k) loan allows you to finance both the cost to repair a home and the cost to buy a home. Essentially, you can buy a house and renovate it before you move in. So, why would you want to use a 203(k) loan?
The answer is most banks and mortgage lenders do not provide home loans for houses that need work. However, most of these homes are priced to sell. So, if you want to buy a house for a good price that needs work, you will have trouble finding the necessary financing (unless you are paying cash). The FHA 203(k) addresses this issue.
FHA 203(k) Loan Process
You apply for an FHA 203(k) loan just like you would with any mortgage. The FHA does not provide the actual financing. Banks and mortgage lenders provide the loan. The FHA insures the mortgage in the event you default (miss 3 consecutive payments or more).
You will need to complete several steps once you receive a pre-qualification or pre-approval before the bank gives you final approval. You will need to choose a house to buy that requires some type of renovations or repairs. Then you line up contractors who can complete the work. Next, you will receive bids from these contractors, which is how much it will cost to complete the work.
Once these initial steps are complete, you will submit it all to the bank. If the bank gives you the okay, the contractor starts the work. Once the contractor finishes the renovations and repairs, you can move into the home. Do keep in mind that these steps listed for a 203(k) loan are what happens in a perfect world. A host of problems or other factors can arise to delay the process, which is not uncommon when you buy a home.
FHA 203(k) Eligibility
Although the Federal Housing Administration has its own set of eligibility guidelines, it is ultimately up to the lender to decide if you qualify. All mortgage lenders have their own lending guidelines (known as lender overlays), but if they want the FHA to insure a loan, they must follow the FHA’s eligibility requirements. In a nutshell, here is what the FHA and lenders want from you.
• Down Payment- The minimum down payment required by the FHA is 3.5 percent. However, lenders who originate 203(k) loans can require higher down payments. A lender may require more money down to hedge against future risk.
• Credit Score- The FHA requires a minimum credit score of 580. However, there are scenarios where borrowers qualified for a rehab loan with a credit score as low as 500. To keep things simple, most lenders require a minimum credit score of 620-640. Food for thought: most conventional mortgages require a minimum score of 720.
• Debt-to-Income Ratio- Also known as your DTI, this ratio is how much of your pre-tax income you spend on your bills. Typically, lenders ask that your DTI does not exceed 43 percent. There are cases where lenders allow DTIs as high as 50 percent.
• Occupancy- The house you want to fix up must be your primary residence. So, if you are looking for a property to fix and flip for a profit, the FHA 203(k) is not an option.
• Loan Amount- The FHA allows you to borrow the lesser of repair costs plus price or 110 percent of the homes proposed future value.
Limited vs. Standard 203(k) Rehab Loans
The FHA offers two types of 203(k) loans. Known as the limited (formerly streamline) and standard, each loan determines how much you can spend on repairs and the type of renovations you can complete. For example, if you want to complete structural repairs, you will need to choose a loan that allows structural work.
The limited 203(k) is for minor repairs and renovations. If you want to remodel the bathrooms and kitchen or replace appliances, you can choose the limited option. However, you cannot complete any structural repairs with a limited loan. The maximum amount you can spend on repairs is $35,000. Here is a short list of repairs you can complete:
• Bathroom/Kitchen Remodel
• Roof Repair/Replacement
• Health/Safety Issues
• Improve Energy Efficiency
The standard 203(k) loan gives you the freedom to complete almost any repair or renovation. You can add rooms, make structural changes, complete landscaping projects or move the house to another location if that is what you want to do.
The only limitations with the standard loan is you cannot add luxury items. Swimming pools, hot tubs, BBQ pits or adding a tennis court are not allowed using the loan. Additionally, if a project takes more than six months to finish, you cannot use the standard 203(k).
Using a 203(k) to Refinance a Mortgage
203(k) loans are not limited to home purchases. You can refinance your current mortgage using a rehab loan. If you have $5,000 or more of renovations or repairs to complete, you can use a 203(k) to refinance your existing mortgage. Additionally, your current mortgage does not need to be an FHA loan. You can refinance practically any mortgage with a rehab loan.
Using Rehab Loans to Gain Instant Equity
If you use your rehab loan correctly, you can gain instant equity on your home purchase. For example, if a home has an “as is” value of $150,000 with a list price of $140,000 and an after-repair value of $200,000, you can buy the home for $140,000 and use up to $35,000 to renovate the home. After all the repairs are complete, you instantly gain $25,000 in equity ($140,000 list price + $35,000 in repairs = $175,000), ($200,000 after-repair value – $175,000 = $25,000 equity).
You would be surprised how many people use similar scenarios to instantly build equity. However, you need to remain patient as the process can take some time. The equity does not just show up once you receive final approval from a lender.
A contractor must complete the work before you gain equity. Additionally, a contractor may need to charge more than the initial bid price if unforeseen problems develop during the renovation. You also have to pay a 1.75 percent upfront mortgage insurance premium and make an additional monthly mortgage insurance premium payment of around .85 percent of the loan amount.
203(k) Loan Drawbacks
As with any home loan, rehab loans have drawbacks. Although these loans offer extensive benefits, they do take much longer to complete than qualifying for a regular mortgage. Because you are working with multiple contractors and asking for bids, it adds another layer of paperwork to an already extensive list of documentation requirements.
You will need to figure out what renovations or repairs you would like to complete and how much you can afford. Remember, the lender rolls your repair costs into the financing you need to buy the home. It is undeniable you will have plenty of preliminary work to complete before you receive final approval, but once you reach the finish line, the rewards are substantial.