Guidelines and Requirements for FHA 203(k) Loans
All FHA loans have very specific requirements that apply to borrowers, lenders, and even the properties in question. Because the 203(k) loan is a subset of the standard FHA loan, many of these requirements are the same for both. However, there are some very specific requirements that pertain to the 203(k) loan alone.
Requirements for Consumers
Most of the requirements for 203(k) loans apply to the borrower, and they will make a significant difference in whether you are able to use this loan program, or if you need to apply for a 203(b) loan instead.
Your credit score is one of the single largest determining factors in whether you can use a 203(k) loan, or if you need to apply for a 203(b) loan, and, by extension the type of property that you can purchase. While the FHA only requires that borrowers have a credit score of 580, most lenders require that you have a credit score of between 620 and 640.
In comparison, the 203(b) loan is open to those with a credit score of 580 and 3.5% of the purchase price as a down payment, or those with scores as low as 500 with 10% of the purchase price as a down payment. The reason lenders require a higher credit score for 203(k) loans is because of the increased risk and the size the loan, even with FHA mortgage insurance.
Note that in addition to being at least 620 to 640, you also need “good” credit in that you cannot have damaged your credit through negligence or carelessness.
Down Payment Amount
Like a conventional FHA loan, the 203(k) loan requires a minimum down payment of 3.5% of the home’s purchase value. That money can come from almost anywhere, as well, including as a gift from a family member or as a bonus from an employer. Personal savings, investment capital and other funding sources are also allowed. While the seller of the home can contribute to paying part of your closing costs, they typically cannot contribute directly to your down payment.
While you may only need a 3.5% down payment, it is always advisable that you put down as much as possible if for no other reason than to reduce the principal of the loan. Also, remember that with all new FHA loans, you are required to pay your mortgage insurance premium regardless of your down payment amount. With a conventional loan, paying 20% or more down negates the need for private mortgage insurance, but FHA loans do not work that way.
Employment and Income
You must be able to show sustained employment for some time. In most instances, this will be a minimum of 12 months, but your lender will have specific requirements in terms of proof of employment and income verification. Be prepared to show paycheck stubs, as well as providing your lender with access to your bank account (via statements).
Anything you can do to show that you are financially stable is recommended here. That includes your tax returns (two years as a minimum), as well as proof that you have experienced no late payments within the preceding 12 months, and have not gone through bankruptcy or foreclosure within the preceding three years.
Debt to Income Ratio
In contrast to other FHA loans, the 203(k) loan requires that borrowers have no more than 45% debt to income ratio, or DTI (the 203(b) loan requires 43% DTI). Someone earning $50,000 per year would need to pay $1,875.00 per month in expenses or less. Note that this does not apply to any sort of discretionary spending, such as groceries or gas for your vehicle. Your DTI is calculated based on recurring expenses, like your car loan, school loans, or utility payments.
Closing costs can be a shock to many home buyers. The good news is that most FHA loans allow you to roll your closing costs into the loan itself. However, while that gets you off the hook now, it does mean that your monthly payments will be higher, and the cost of your home will also increase commensurately.
Note that you do have some options to reduce your closing costs. For instance, the FHA allows you to ask the seller to pay up to 6% of your closing costs, and you may be able to get other parties to contribute as well (but not for more than 6%).
Requirements for Lenders
Lenders participating in FHA loan programs must meet a number of important requirements. These speak to everything from the lender’s stability and history to their net worth. However, understand that not all lenders participate in FHA programs – it is voluntary. Those who do participate, however, must be direct endorsement lenders, and they must have an FHA-approved underwriter employed within the business.
Other requirements for FHA-participating lenders include the following:
Must have a control plan in place
Must submit audited financial statements to the FHA on a regular basis
Must have at least three years’ experience originating loans on single-family homes
Must carry a fidelity bond
Must carry errors and omissions insurance with a minimum of $300,000 in protection
Must be licensed to operate in the state or states they serve
Must have at least $1 million in net worth, plus 1% of the lender’s total value of FHA-related business over $25 million
If you are considering a lender who does not meet these requirements, you may still be able to move forward with an FHA loan, so long as the lender is sponsored by a direct endorsement lender that does meet FHA requirements.
Requirements for Properties
While both lenders and borrowers must comply with a wide range of requirements, you’ll find that 203(k) loans actually put most of the focus on the property, as well as the renovations that need to be made, which we’ll address in a separate section. For the property, the requirements are as follows:
It must be at least one-year-old.
It must require at least $5,000 in rehabilitation/repair/renovation costs. However, under $35,000 in costs means you will need to go with a Streamlined/Limited 203(k) loan, as a conventional 203(k) loan is only usable for properties with significant renovation needs (over $35,000).
It must be a qualifying property type, which can be:
A single-family home
1-4 unit homes built at least a year ago (such as town homes)
1-4 building condos in need of interior improvements only
Modular units and even homes located off-property that can be moved to your current site
Conversion of a single unit property in a multi-unit property
Purchase of a demolished or torn down property with a section of original foundation remaining
In most instances, the properties purchased with a 203(k) loan are located in urban and suburban areas. If you are looking for a property in a rural area, it is probably better to go with a USDA loan.
However, you will find that the requirements are less stringent than purchasing a home with a 203(b) loan simply because a 203(k) loan can be used to make a property compliant with overall FHA/HUD requirements. This is because properties that would usually not qualify for purchase can be rehabbed into compliance with FHA/HUD standards.
Once the repairs or renovations are finished, the property will need to be inspected by a qualified appraiser to ensure that the property does conform to HUD’s requirements for health, safety, and livability. There are numerous requirements that apply, but the full list can be found in the HUD Official FHA Guidelines Handbook, which can be downloaded in PDF form here. A few examples of these requirements include the following:
The lot must be graded to route water away from the foundation.
Crawlspaces must be properly ventilated.
All bedrooms must have an egress route to the outside.
The water must be drinkable.
The heating system must be in working condition.
The foundation cannot be damaged.
The septic system must be in good condition.
There must be no risk of lead poisoning.
Again, the 203(k) loan can be used to bring a noncompliant home into line with these requirements. For instance, if the home’s heater is faulty, or is missing completely, the loan can be used to repair or replace it. The same applies to things like foundation damage, crawlspace ventilation, exterior windows in bedrooms usable for escape, and the like.
Requirements for Renovations
In addition to the lender, borrower and property requirements, there are significant requirements that pertain to the renovations for the property. These are the “make or break it” considerations that you will need to bear in mind prior to deciding which FHA loan type is right for your needs.
The following list is provided by HUD/FHA and is what the organization considers “eligible activities” for conventional 203(k) loans. Note that this list does not apply to Streamlined/Limited 203(k) loans.
According to HUD, “The extent of the rehabilitation covered by Section 203(k) insurance may range from relatively minor (though exceeding $5000 in cost) to virtual reconstruction: a home that has been demolished or will be razed as part of rehabilitation is eligible, for example, provided that the existing foundation system remains in place. Section 203(k) insured loans can finance the rehabilitation of the residential portion of a property that also has non-residential uses; they can also cover the conversion of a property of any size to a one- to four- unit structure.
However, there are additional considerations and requirements. These include the following:
You cannot do any of the renovations or repairs yourself.
You will need to hire a 203(k) consultant to create a work-write up and help you find a contractor
You must work with a 203(k) contractor approved by the lender.
The renovations must be completed after closing on the loan.
Renovation work must begin within 30 days of closing on your loan.
All renovations and repairs must be completed within six months of closing.
All renovations must be paid for with funds from the 203(k) loan.
Renovations must bring the property into alignment with HUD/FHA requirements (no additional work must be necessary for compliance).
After all renovation work is completed, the home must be inspected/appraised by an FHA-compliant appraiser.
You cannot undertake projects that will require more than six months to complete.
You cannot undertake minor landscaping projects.
In addition to these requirements, there are other considerations that complicate the process and create a longer timeline while potentially driving up headaches and holdups. However, the more prepared you are, the easier the entire process will be.