203(k) loan: What it is and 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 for people who need money for necessary or cosmetic changes. 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. 

Key takeaways

• A 203(k) loan is a government-backed home loan that you can use to buy a home or refinance your mortgage. You can use some of the loan’s proceeds to pay for home repair, upgrades and improvement projects.
• These loans have relatively low credit score and down payment requirements. 
• But there are also strict 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 type of home rehab—or renovation—loan that allows you to include the cost of repairs, improvements, upgrades and other eligible projects in your mortgage. You can take out a 203(k) loan to buy a fixer-upper or refinance an existing mortgage with a 203(k) loan to get funds for projects.

203(k) loans are backed by the United States Federal Housing Administration (FHA) and tend to be easier 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.

Most types of mortgages only give you the money you need to purchase a home or refinance your mortgage. A 203(k) loan lets you borrow additional money for repairs, improvements and upgrades and pay off the debt along with your monthly mortgage payments. 

Rolling those expenses into your mortgage might help you qualify for a lower interest rate than you might get with other credit options. And the long repayment term can lead to low monthly payments. As with other mortgages, you may be able to choose between a 15- or 30-year term and a fixed or adjustable interest rate. 

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. You have to hire licensed contractors to do the work, and you may want to look for contractors who have experience with 203(k) projects and can meet the paperwork and 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. 

Depending on the estimated cost and the types of projects you want to complete, you may be able to choose between two versions of 203(k) loan: a standard 203(k) loan and what’s known as a limited or streamlined 203(k) loan. 

Standard 203(k) loan

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. 
• Have a $5,000 loan minimum but no maximum loan cap.
• Require you to hire a United States Department of Housing and Urban Development (HUD) consultant—your lender can help you find one—who will get estimates from contractors, oversee the projects and sign off on their completion.

Limited 203(k) loan

A limited—or streamlined—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 a $35,000 or $50,000 maximum, including 10% to 20% set aside in a contingency fund to cover unforeseen project costs. 
• Don’t require a HUD-approved 203(k) consultant.

You can use either a standard or limited 203(k) loan to finance basic home repairs, improvements and upgrades. These can include cosmetic changes, such as landscaping and painting, as well as major improvements and functional upgrades, such as an addition or accessibility features. You can even use a 203(k) loan to completely rebuild a home on top of an existing foundation and to convert the property into a one-to-four-unit structure. 

However, you have to use the loan 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. However, 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 expect to complete within six months. Additionally, they must start work within 30 days of closing. You may be able to request an extension if a project isn’t done in time, but the timeline requirements could rule out some major repairs or renovations. 

Property age and type

A property must be at least one year old if you want to buy it with a 203(k) loan, but there’s no maximum age limit. The property also must be a one-to-four-unit single-family structure. The loans are an option for interior repairs on individual condominium units in certain condos (but not cooperative units) and for manufactured homes when the renovations don’t affect structural components. 

Minimum credit score

As with other types of loans, your credit score can affect your eligibility and down payment requirements. Lenders can set their credit score requirements. However, at a minimum, you need a 580 credit score if you want to put a 3.5% down payment. Or you might qualify with a 500 to 579 credit score and a 10% down payment. 

Loan and loan-to-value (LTV) limits

Although standard 203(k) loans don’t have a preset maximum, there are loan limits that depend on the property’s size, location, value and the cost of the renovations. 

The maximum LTV is 96.5% for purchases and 97.75% for refinancing. To determine the maximum loan amount, you can then multiply those percentages by the lesser of:

• The current value of the home plus the total costs for the renovations.
• 110% of what the property will be worth after the renovations are complete. 

For example, you might want to purchase a home for $400,000 that needs an additional $100,000 of renovations, and the estimated post-renovation value is $475,000. For simplicity’s sake, in this example, you qualify for the maximum 96.5% LTV—and a 3.5% down payment—and there are no additional fees. 

You can multiply that 96.5% LTV by the lesser of $500,000—the current value of the property plus renovations—and $522,500—110% of $475,000—to find your total loan amount. In this example, your maximum loan amount would be $482,500—which is $500,000 x .965. 

Upfront and monthly insurance premiums

As with other types of FHA loans, you may have to pay an upfront mortgage insurance premium that’s 1.75% of your loan amount, plus an annual mortgage insurance premium that may be 0.45% to 1.05% of your home’s post-renovation value. The annual premiums are often split into monthly premiums and added to your mortgage payments.

Although a 203(k) could be a good option if you’re looking to buy a fixer-upper, rebuild a home or improve your home, there are also other types of mortgages that can include money for building, upgrade and renovation costs. 

Conventional rehab loans

There are several conventional renovation loan programs that work similarly to 203(k) loans, such as the Fannie Mae HomeStyle, Freddie Mac CHOICEReno eXPress® and Freddie Mac CHOICERenovation® mortgages. These might be better options if you have longer-term projects or want to include luxury items that the 203(k) loan program doesn’t allow. However, you may need a higher down payment or credit score to qualify.  

Cash-out refinancing

If you have equity in your home, you could look into different types of cash-out refinance mortgages. These let you borrow more than your current mortgage and keep the difference in cash, which you can use for home improvements and repairs. 

USDA renovation loans

The United States Department of Agriculture (USDA) renovation loan program could be an option if you buy a home in a USDA-designated rural area. Unlike 203(k) loans, there’s no down payment requirement for low- and very-low-income households who take out a USDA home loan. 

VA renovation loans

Eligible veterans could look into United States Department of Veterans Affairs (VA) renovation loans. Similar to other types of VA loans, there is a one-time funding fee but no down payment requirement. However, you might not be able to take on as many projects as you could with a 203(k) loan because lenders might cap the renovation budget at $50,000, including a reserve fund. 

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. The loan program might also make buying a fixer-upper in an otherwise unaffordable area an option for buyers who have low credit scores or can’t afford a large down payment.