While not widely advertised, a federally backed program called the FHA 203(k) loan might just be your ticket to getting that home improvement project done. It is also a way to help streamline the process so that you are not spending more time talking to lenders than you are to architects and contractors.
The main caveat with this program is that you must secure the FHA 203(k) while you are negotiating your first-mortgage purchase of the home. Be forewarned that the FHA 203(k) loan is not for everyone, even for those who qualify. One reason is its inevitable red tape. In fact, HUD acknowledges this and has instituted a program of certifying independent 203(k) consultants who can smooth the process for you.
- "Rehab loan" is the nickname for FHA 203(k) Mortgage Insurance.
- This program is administered by the U.S. Department of Housing and Urban Development (HUD).
- You can get up to $35,000 for improvements (minimum amount you can take is $5,000).
- You must take this loan at the time you purchase the house.
- Red tape is involved with this loan, but there are consultants who can help you.
- You cannot take the loan for just anything. You can only use it for allowable home improvement projects, which tend to run along the lines of safety, plumbing, modernization, expansion, and more.
What is an FHA 203(k) Rehab Loan?
Securing financing when you find that diamond-in-the-rough house can be a real problem. In your mind's eye, you just know that it will be the belle of the block, but lenders may not share that vision. Even if you are able to get financing to purchase the house, you still face the daunting task of securing the second set of financing for the rehab.
An FHA 203(k) loan is a combined mortgage loan and remodeling loan issued by mortgage lenders and insured by HUD. You can get up to a $35,000 loan in order to improve your home, but only for a limited number of home improvement projects.
Why is the government being so generous? It's not so much about generosity as it is about the larger, global picture and the U.S. economy. Via HUD and the FHA 203(k) program, the government is more concerned about revitalizing or maintaining entire communities and ensuring that the nation's stock of existing houses does not implode. Still, you can personally benefit from these wide-ranging motives.
Helping to Solve the Equity Gap Problem
The benefit to the FHA 203(k) program is that it fills in the missing equity needed by homeowners of recently purchased homes.
Buying a house that needs help and securing financing for it at the same time is a paradox. You need to first build up equity in the house before you can take out another loan on it. Equity is built up typically by paying down principal on the loan while the home gains in value. This takes time.
A less desirable alternative is to get an unsecured or signature loan for that remodel work. Even if you can get an unsecured loan, interest rates will be far higher than if you get a loan that uses your home as collateral.
Without the FHA 203(k), homeowners typically will first find a house that needs tender loving care. Next, they apply for a first mortgage loan that covers only the purchase price of the house. While this would seem ideal, borrowers cannot ask that an extra $35,000 be added to that first mortgage loan. First mortgage loans cover only that purchase price and nothing more. After the purchase of the home and after having owned the house for a while, the homeowner would apply for a second mortgage, home equity loan, or HELOC (home equity line of credit) to pay for the remodels.
What HUD/FHA does is fill in that gap between the house's current equity and the amount of the loan by insuring the loan. In essence, it is like the rich uncle who steps in and says, "I will act as a backer for this loan until the house can be improved."
- You get one initial mortgage loan to cover purchasing and remodeling your intended home. This saves you from taking out two separate loans.
- This loan acts as a good push to get you started on home improvements. Because the program expects you to use the money for rehab, you must get started within a reasonable amount of time. This prevents you from procrastinating for years.
- Unlike some loans that have short repayment periods, FHA 203(k) loans parallel the length of your mortgage loan. For example, if you have a traditional 30-year mortgage, you also have 30 years to pay back the remodeling portion of the loan.
- Because of program requirements, your loan closing period will usually be longer than with a conventional loan. Closing periods range from 60 to 90 days.
- Your choice of lenders is limited. Instead, you need to work off of HUD's list of approved FHA 203(k) lenders.
- A significant amount of red tape is involved. In order to qualify for the loan, you will need to submit a detailed proposal, including architectural drawings.
List of Allowable Renovations
The allowed remodels list sounds restrictive at first. But keep in mind that these definitions can be stretched and still remain legitimate remodels. Generally, HUD is concerned that 203(k) money not be used for "luxury items and improvements," as they term it.
Yet they also stress that "painting, room additions, decks, and other items even if the home does not need any other improvements" will fall within the scope of 203(k). Allowed projects:
- Remodels for a disabled person
- Modernizing an outdated home
- Improving your home's energy efficiency
- Landscaping and other exterior site work
- Roof, gutter, and downspout installation or replacement
- Altering the home's structure and/or reconstructing the home
- Eliminating safety hazards
- Aesthetic improvements
- Plumbing improvements, including well and septic system work
- Floor additions/replacements (includes floor treatments)
Is FHA 203(k) a Miracle Loan?
On the face of it, the FHA 203(k) rehab loan (often erroneously referred to as a 201k loan) can seem like a miracle. After all, you get money to buy the house and extra money to remodel the house, and you get it all right away. However, it is important to remember that:
- This is still a loan, not a grant. It must be paid back, though you do have the entire length of the loan to pay it back.
- Because this is a loan, interest is charged. You will want to consult the payment schedule to see how much total interest this loan is costing you for the entire life of the loan.
- Due to the longer closing period, the FHA 203(k) may not help you in a highly competitive market where you need to purchase quickly and without complications.