The FHA 203(k) Rehab Loan

The Federal Housing Administration’s 203(k) program is a purchase or refinance rehabilitation loan. This loan program allows a borrower with limited funds to purchase, or refinance, and fix up a one-to four-unit property. Although it must be owner-occupied, a portion of the property can be for commercial use. As long as part of the existing foundation remains in place, properties which are demolished (or scheduled to be as part of the rehabilitation) are eligible. Improvements made under this program may be significant or minor, but a minimum of $5,000 in improvements must be made, and they must fall within certain categories. Additionally, there is no upfront Mortgage Insurance Premium (MIP) charged on 203(k) loans.

If needed, there are some repairs which are mandatory: thermal protection (insulation, etc.), smoke detectors, wood-boring pest and moisture damage, septic, well or water service, and elimination of health and safety hazards. Other eligible repairs or improvements to meet the first $5,000 minimum requirement include modernization and functional changes; reconditioning or replacement of plumbing, heating, air conditioning and electrical systems; aesthetic upgrades and the elimination of obsolescence; roofing, guttering, and downspouts; damaged flooring; and energy conservation upgrades. Beyond these, virtually any other improvements can be made, such as purchasing new appliances or repairing a pool.

Many additional costs can be financed into the 203(k) loan, including permits, inspection costs, work write-ups, and supplemental fees. Other expenses that can be rolled into the loan include the escrow for contingency costs and up to six months worth of the proposed mortgage payment. For structures over thirty-years old, FHA requires between ten- and twenty percent of the cost of scheduled repairs to be financed into the loan for escrows. If the dwelling is unlivable while the work is being done, up to six monthly payments can be financed. The maximum amount of time allowed for the completion of repairs is six months (hence the allowable six months of financed payments).

Briefly, here’s how the program works. The loan will be used to purchase a piece of property, or pay off an existing loan for a refinance. The first step is to be prequalified by a lender who has experience with 203(k) loans. Once prequalified, find a U.S. Department of Housing and Urban Development (HUD)-approved Consultant. Your lender or the HUD website can direct you to consultants in your area.

Have the consultant do a feasibility study on the property; this is a quick estimate of the repairs that need to be completed, as well as any other repairs that you want done on the property. Although not required, it will tell you if the cost is in the range that you’re willing to pay to fix up the property. If the costs are acceptable, authorize the consultant to do a work write-up, which is a relatively expensive item-by-item breakdown of each item to be repaired, as well as the estimated cost. (It can be financed into the loan.) Once agreed upon, the lender will then order an appraisal based on the write-up. The appraisal will give an “after-improvements” value.

Bids can then be solicited from builders for the proposed repairs. Acceptable bids cannot exceed the cost given in the write-up. If the winning bid is lower than the write-up, the loan will still be based on the write-up amount. Any money left over after the rehab work is completed can be applied to the loan principal or used for additional repairs; it cannot go to the borrower.

During this time, the loan is underwritten. After loan approval, the loan closes. There is an initial payment for the purchase or refinance payoff of the property. The remaining funds are held in escrow by the lender until the work is completed. As the rehab progresses, the builder can request draws on the escrowed funds to pay for the work done to that point. The consultant will perform an inspection, and upon approval the lender will release the requested funds. This continues until the completion of the project. For additional information about the 203(k) loan program, be sure to visit HUD’s website.