203(k) loan: What it is & how it works

Buying a home that needs repairs and improvements can be an affordable way to get your foot in the door of homeownership. But paying for those home renovations can be difficult.

The 203(k) loan program is a government-backed option that allows you to take out one loan to both purchase and renovate a home. So if you’re considering buying a home that needs some love—or refinancing your mortgage to pay for renovations—review how the 203(k) loan might help you achieve your goals.

What you’ll learn:

• A 203(k) is a government-backed home loan that you can use to buy a home or refinance your mortgage and pay for necessary or cosmetic renovations. 

• Federal Housing Administration (FHA) 203(k) loans come in two types: standard and limited.

• These loans have relatively low credit score and down payment requirements. 

• But there are also rules, requirements and restrictions that you’ll need to follow if you want to use a 203(k) loan.

A 203(k) loan is a mortgage backed by the FHA that allows you to include the cost of renovations like repairs, improvements, upgrades and other eligible projects in your loan. You can take out a 203(k) loan to buy a fixer-upper or refinance an existing mortgage to get funds for projects.

A 203(k) rehab loan may be easier for low- to moderate-income families to qualify for than conventional loans from mortgage lenders. However, you still need to meet an FHA-approved lender’s eligibility requirements and follow the 203(k) program rules.

When you take out a 203(k) loan, the lender will pay the seller—or your mortgage servicer if you’re refinancing—and then set aside the home project funds in an escrow account. As with other mortgages, you may be able to choose between a 15- or 30-year term and a fixed or adjustable interest rate. You have to hire licensed contractors to complete the work, so it’s a good idea to look for contractors who have experience with 203(k) projects that can meet the timeline requirements.

Once you start the work, your lender can make an initial payment directly to the contractors to cover some of the material and labor costs. After that, the lender will release progress payments and finish paying the contractors once the work is done. In some cases, a 203(k) loan can help cover temporary housing expenses if you need to live elsewhere during the renovations.

There are two types of 203(k) loans: a standard 203(k) loan and a limited 203(k) loan. Choosing between the two versions depends on the estimated cost and the types of projects you want to complete.

The standard 203(k) loan is a good option if you’re buying a fixer-upper or need money for major home improvement projects. Standard 203(k) loans: 

• Are for major projects, including structural repairs and health and safety improvements. 

• Have a $5,000 loan minimum but no maximum loan cap—and the total property value must stay under the FHA mortgage limits for the area.

• Require you to hire a U.S. Department of Housing and Urban Development (HUD) consultant, selected by the lender.

A limited 203(k) loan could be a good option if you have small projects in mind. Limited 203(k) loans:

• Are for minor and nonstructural projects, such as painting, replacing flooring and updating electrical systems.

• Have no minimum loan amount but allow borrowers a maximum of $75,000. 

• Don’t require a HUD-approved 203(k) consultant.

You can use either a standard or limited 203(k) loan to finance both minor and major improvements, such as:

• Making cosmetic changes like landscaping and painting

• Repairing or installing fences, decks, patios or porches

• Converting a single-family home from one unit to up to four units 

• Rebuilding on top of an existing foundation 

• Adding accessibility features

• Installing new appliances

• Replacing or upgrading HVAC or electrical systems

The loan needs to be used for your primary residence—not an investment property. You also can’t use 203(k) loans for luxury items, such as a new swimming pool. But if the home already has a swimming pool, you can use the loan to repair it. You can also use the loan to improve residential areas of mixed-use properties that are primarily residential, but you can’t finance improvements for commercial use.

In addition to using the funds for an eligible project, you’ll need to meet the other 203(k) loan requirements and qualify for a 203(k) loan from an FHA-approved lender. Some of the factors that might affect your eligibility include:

• Project timeline: You can only use a 203(k) loan for renovations that your contractors complete in a specific time frame—12 months for a standard 203(k) loan and nine months for a limited 203(k) loan. Extensions are allowed in some cases if a project isn’t done in time, but the timeline requirements could rule out some major repairs or renovations.

• Property requirements: A property must be a one- to four-unit single-family structure and at least one year old, but there’s no maximum age limit. It must be a primary residence, too—you can’t use a 203(k) if you plan on flipping the home. 

• Minimum credit score: As with other types of loans, your credit scores can affect your eligibility and down payment requirements. At a minimum, you typically need a 580 credit score if you want to put down a 3.5% down payment. Or you might qualify with a 500-579 credit score and a 10% down payment.

• Repair amount: Limited 203(k) rehab loans can be used toward up to $75,000 in renovation costs. With a standard 203(k) loan, there’s no maximum, but it should involve major work that costs at least $5,000.

There are a few advantages and disadvantages to 203(k) loans to keep in mind. 

The pros include:

• Lower down payments and interest rates: In most cases, you can put less money down with a 203(k) loan. And because it’s backed by the FHA, you may see lower interest rates than a conventional home improvement loan.

• Lower minimum credit score requirements: A 203(k) loan typically has more flexible credit requirements, which may improve your chances of approval.

• Financing combined in a single loan: Instead of taking out separate mortgage and home renovation loans, a 203(k) loan combines both loans into one.

Cons of 203(k) loans include:

• FHA mortgage insurance premium requirements: As with other types of FHA loans, you may have to pay an up-front mortgage insurance premium. The annual premiums are often split into monthly premiums and added to your mortgage payments.

• A longer approval and closing process: Due to the amount of documentation involved, sometimes the approval and closing process through both the FHA and the lender can take extra time.

• Less availability through lenders: Not all lenders offer 203(k) loans. And sometimes, those that do offer them may have higher credit score minimums than the FHA itself requires.

After you’ve found a property to purchase and renovate, you can follow these steps to get a 203(k) loan:

1. Find an FHA-approved lender and select a standard or limited 203(k) loan depending on your needs.

2. Ensure the property meets the FHA guidelines for the renovations needed.

3. Meet with a 203(k) HUD-approved consultant if using a standard 203(k) loan—this step is optional for a limited 203(k) loan.

4. Close on the loan, and then work with a licensed contractor to get started on the renovations. 

5. Contact the 203(k) consultant after the first phase of renovations is complete to request an inspection and draw additional funds.

6. When work is completed, you’ll provide a release letter, and the consultant will verify all work is done. The lender will then complete the project and release any remaining escrow funds.

A 203(k) is a type of FHA-guaranteed loan that can help homebuyers and owners add the cost of home repairs, upgrades and improvement projects to their mortgage.

By folding in the renovation costs, you can take advantage of a mortgage’s relatively low interest rate and long repayment term while making your home safe, efficient and enjoyable. If this is your first home, it might help to learn more about other first-time homebuyer loans that can help you access affordable mortgages with flexible terms.