There are four main types of home loans; FHA, Conventional, VA and USDA. Each has unique characteristics and varying target audiences. In this post we are looking at the FHA renovation loan financing using an FHA 203K loan. Before we dive in too deep, let’s take a step back and look at The FHA 203(b).
A 203(b) loan is the plain vanilla FHA loan on the market. The numbers reference the section of the code that defines what an FHA loan can be used for. According to FHA.gov, an “FHA 203(b) may be used to purchase or refinance a new or existing one-to-four family home in both urban and rural areas including manufactured homes on permanent foundations.” There are several formal definitions for FHA loans, and we will perhaps look at those in a future post, but from a lenders perspective (more precisely my perspective),an FHA loan is the go-to loan structure if the buyer has:
- Credit blemishes,
- Recent derogatory events,
- Or a credit score under 640.
There are no hard and fast rules about when you use an FHA loan and when you don’t. In todays market, they are generally most useful for the above categories. FHA loans also have a low downpayment requirement (just 3.5%) which some will tout as a benefit. However, there are several 3% down conventional loan options on the market right now so the low downpayment requirement, in my eyes, isn’t as much of a draw as it once was. At a high level, a regular FHA loan will require that the buyer be able to roll their suitcase in and unpack. Meaning the property is ready to go with no required repairs. However, many properties on the market today require repairs. That is where the FHA 203K comes in.
The FHA 203k is the section of the FHA code that allows for renovation loans. The 203K, as they are affectionately known, allows the borrower to borrow funds to purchase and renovate a one to four unit residential property. 203K’s fall into two categories; Full K and a Streamlined K.
- Streamlined K- the streamlined 203K is offered to homebuyers or homeowners when less than $35,000 in repairs are required.
- Full K – the full K will allow you to buy a current property, and renovate as much as is required. As long as two foundational walls remain from the original construction, you can get as much renovation financing as your ratios will allow.
One important thing to note at this juncture is you must stay within FHA guidelines for debt to income ratios. Generally (and I use that term loosely), you can not spend more than 31% of your income on the new house, and no more than 50% of your income on the new house plus what’s on your credit report.
Estimated costs and guidelines: 203K:
When purchasing a property using an FHA 203K there are additional costs and holdbacks you should be aware of. These costs are unlikely to be a part of a non-renovation purchase.
The streamlined 203K will allow a borrower to use up to $35,000 towards repair costs in the home. There are lots of twists and turns in the 203K process, but one of the more important ones to note up front is the contingency reserve. The borrower is required to hold a dollar amount in contingency on any 203K loan. For a property where the utilities are on and can be tested as a part of the inspection cycle, the contingency requirement is 10%. If the utilities are not on at the time of inspection, a 15% contingency is required. It like to call the contingency fund the ‘uh-oh’ fund.’ The contingency is held just in case something comes up that you could not foresee before purchase. If you are able to get through the entire renovation without accessing the contingency fund, that dollar amount is applied to the principal of your loan.
On a Full K transaction, the renovation and contingency costs must fit into your DTI ratio guidelines.
There are some property types that do not qualify for an FHA loan. Those property types, as of the date of this post, are:
- Manufactured Homes
- Mobile Homes
- Geodesic Domes
- Working farms/ranches
- Unimproved land and property currently in littigation
- Illinois land trust
- New construction completed within the last 12-months
- Tear down homes
- Construction of detached properties
- Land Trust
- Rehabilitation involving self help
These standards are enacted to meet basic constructs of the HUD minimum property standard guidelines. The function of the FHA consultant is to ensure your repairs will be in concert with these guidelines before closing. Once you have completed the renovation, the house should be in line with FHA guidelines. The FHA consultants job is to review the contractor bid and appraiser requirements to be certain your home will be eligible for FHA financing once completed.
There are several guidelines you must meet to have eligable improvements to the home. They include but are not limited to:
- Elimination f health and safety hazards
- Can be used to convert a one-family dwelling to at two,three or four family dwelling. An existing multi-unit can be decreased to a one to four family.
- A minimum of $5,000 must be used in part for renovation and/or repair of an existing property. Minor or cosmetic repairs or new fixtures alone, such as stoves and refrigerators are not acceptable.
- Creating accessibility for persons with disabilities
- Making energy conservation improvements
- Making changes for improved functions and modernization
As always, if you have questions or are in the market for a new home loan, please don’t hesitate to contact me!