A successful home mortgage is often half the battle. But what happens if it takes a lot of money to renovate your house, which reduces the benefits of taking out a mortgage? Or vice versa, you are well aware of the problems at home, but the down payment of a regular mortgage could suit you better. Which option would be preferable in this case? In this text, we will look at how a 203(k) loan works and how such a mortgage can be helpful for a homeowner.
What is a 203(k) loan?
An FHA (Federal Housing Administration) 203(k) loan allows you to combine the cost of buying and renovating a home into one loan. After completing the repair, you can instantly increase your capital based on the increased value of housing. It also allows current homeowners to finance renovations to their existing homes.
This type of mortgage agreement is attractive to first-time homebuyers because the credit rating and down payment requirements are more relaxed than most conventional loans.
What are the requirements for borrowers?
If your credit score exceeds 580, you can finance up to 96.5% of purchases and repairs.
If your rating is between 500 and 579, your down payment must be at least 10%. Approximately 80% of US borrowers fall under this definition.
203(k) loan types
- Limited — this mortgage allows you to finance non-structural repairs. For example, when you do not break the walls entirely and make only minor changes. This loan includes upgrades up to $35k with no minimum loan amount. You can use the funds to renovate the property or prepare the house for sale. Examples of home renovations: updating the kitchen or new carpet.
- Standard — this mortgage offers a broader range of refurbishment options, including structural repairs. Requires a minimum mortgage of $5k for repairs. This type of mortgage must include interaction with a 203(k) loan advisor who will work with the lender and borrower. With a Standard 203(k) loan, part of the mortgage is paid off to the home’s seller, while the rest is held in a particular account to pay for repairs.
How a 203(k) loan works. How do I get a 203(k) loan?
If you are interested in a 203(k) loan, your first step is to find a lender who will offer it. Only some lenders offer FHA mortgages; if they do, they may not provide a 203(k) loan option.
This process can be divided into several stages:
1. Finding a lender
The Department of Housing and Urban Development can provide you with a list of all lenders that offered 203(k) loans in the past year. Choose one close to you (or works in your state) and determine its terms and conditions.
It is necessary to analyze what needs to be repaired in the house and determine the size of the future loan and the project scope. A well-executed inspection is vital because it helps determine the extent of renovation needed for the home you are purchasing. A HUD-certified inspector conducts the inspection, ensuring compliance with FHA standards.
Their duties include:
- Visiting the home.
- Describing in detail the work to be done.
- Conducting a general review of the condition of the dwelling.
It may be that your home is basically beyond repair, as there is severe damage, such as an unrepairable crack in the foundation. If the inspector does not note all the details, they will not receive funding in the future.
3. Obtaining an estimate and hiring a contractor
After the inspector conducts an inspection, an estimate is prepared. Based on the forecast, you need to determine which repair contractors to hire. It is customary for a general contractor to collaborate with other contractors. Also, you may need to hire individual specialized contractors such as a roofer, plumber, and electrician. Unfortunately, it is impossible to hire the first acquaintances that come across. You need people with at least a license in your state.
Types of work that can be done with a 203(k) loan:
- Addressing health and safety issues.
- Installing a new roof, gutters, and downspouts.
- Floor replacement.
- Making structural changes or remodeling parts of the house.
- Providing better access for a person with special needs.
- Energy saving improvement.
- Landscaping (for example, cutting down trees that have grown and threatened the house).
- General repair and modernization of the house and improvement of its overall appearance.
4. Invitation of an appraiser
Once you have determined the scope of the repair, the lender will hire an FHA-approved estimator to evaluate your estimate.
The total mortgage amount will be: the property’s value before the renovation plus the cost, or 110% of the appraised value after the renovation, whichever is less.
A valuation far exceeding the home’s current value indicates that the renovation will pay off for the homeowner. In addition, if you buy a house that needs a lot of work in an area with excellent homes and the necessary repairs are regularly carried out by their owners, your property will not lose its value.
5. Carrying out the necessary transactions
Once the cost is set, the money reserved for the repair is transferred to the borrower’s name at the depository bank. Payments to the contractor are made as the work is completed and the quality of its performance is checked. The amount will also include a reserve (approximately 10%) in case of unforeseen circumstances.
Reserve funds are vital in case more problems show up in the house. If the work on the place is so extensive that you won’t live in it during the renovation, you can finance up to six months of mortgage payments. So you don’t have to pay for the house you live in or buy.
Is taking a 203(k) loan a good idea?
The main benefit of such a loan is the ability to use it for a house hack strategy. That is, generating income from your property.
Many do the house hack with a regular mortgage, without using the state FHA insurance program — this gives you more freedom and does not have to account for every step. But using FHA or a 203k loan is also interesting due to the higher ROI.
There are even fewer risks here because the bank controls the whole process. They give you money for licensed contractors, unlike when you do the repair yourself, and, in the end, it turns out that the inspector does not approve it, and you have to redo everything from the beginning.
How a 203(k) loan works. Conclusion
If you’re a beginner investor, a 203(k) loan is a great way to see if you’re interested in renovating and reselling (or renting) homes. Although you are required to live in this house for 1 year, this requirement is the only strong restriction.
Also, this option is suitable if you have found any house and want to live there for a year, but it has “flaws” — an old bathroom, kitchen, an unfinished garage, or a basement. Negotiate with the seller about discounts for the house and start repairing! In a year, sell this house or refinance, rent it out, and look for a new one. The program does not prohibit using the mortgage as often as you like.
We recommend consulting with experts to ensure you get the most successful loan for any mortgage issues. Therefore, sign up for a consultation at LBC Mortgage to assess your financing options and save time and money!