Weighing the Pros and Cons of FHA 203(k) Loans
An easy-to-qualify-for, all-in-one loan that covers a mortgage and renovation costs—what could be better?
An FHA renovation loan comes with a lot of benefits, but before you learn how to apply for a 203(k) loan, it’s important to weigh the pros and cons of this kind of subsidization to make sure it’s right for you.
Below we’ve gathered the top FHA 203(k) loan pros and cons. Some features, like renovation oversight, could hover between each of these lists, depending on your needs and preferences. Read on to find out how the standard 203(k) FHA loan program stacks up for you.
Pros of an FHA 203(k) Loan
Let’s start with the sunny side up on the list of pros and cons of 203(k) loan experiences. Here are the primary advantages an FHA renovation loan can provide home buyers:
A Lower Down Payment
For conventional loans, a 10% down payment minimum is common. But standard 203(k) FHA loans can offer something potentially even better, such as:
- A 3.5% down payment if your credit score is at least 580
- A 10% down payment with a credit score between 500 and 579
- A 3.5% down payment with a low credit score or high DTI
Easier Qualification Criteria
The Federal Housing Administration (FHA) provides government-backed insurance to lenders for FHA loans to help those with lower income or credit buy homes. This allows lenders to use an easier set of qualification criteria than conventional loan programs if you’re looking for an FHA loan with bad credit, such as:1
- A 500 to 580 credit score minimum, rather than 620 or higher
- A 43% debt-to-income ratio (DTI), up to 50% in some cases, rather than 36%
- Eligibility three years after a foreclosure, rather than seven
- Eligibility up to two years after a bankruptcy, rather than four
Additionally, some can provide more flexibility when it comes to credit history details like late payments.
A Single Loan, Process, and Payment
If you’re shopping for a fixer-upper, juggling the application for a mortgage plus separate funding for repairs can be difficult. You may not have the ability to secure home equity loans or credit if you’ve just bought the property with a low down payment. What’s more, high-interest personal loans or credit cards can strain your finances.
Wrapping it all into one process, then, can help the lender understand the need for renovations and how they’ll increase property value, increasing your marketability. Plus, you’ll only be responsible for a single monthly payment for your FHA 203(k) mortgage loan.
A Faster Home Equity Gain
What is home equity? Equity is how much of your home’s current value you own (vs. the bank). The most common method to increase equity is time. As months and years go by, equity tips in your favor via the monthly mortgage payments you make, along with real estate values likely to increase over time.
The best way to boost your equity quickly, however, is to make property improvements. If you start with a property valued at $150,000 and increase its value to $210,000 in six months, you’ve just gained $60,000 in equity.
While equity will continue to multiply as time goes on, getting a head-start with an FHA 203(k) loan provides a valuable asset you can borrow against for urgent needs, and you’ll make that much more profit if you sell your home.
The FHA requires lenders to provide significant oversight of the renovation process instead of just writing a check and setting homeowners free to figure it out themselves. Particularly for construction newbies, the guidelines can help them understand how to plan the projects, vet contractors, review estimates and invoices, and stay on track.
You’ll work with an FHA 203(k) consultant and your loan officer to:2
- Get competitive bids from licensed, insured contractors with 203(k) experience
- Select a reliable contractor to partner with on your home renovations
- Submit a detailed official bid with accurate costs on all proposed renovations
- Have the property appraised and evaluated for mandatory safety renovation needs
- Complete the work within six months of loan closing
The lender will approve each stage and ensure your renovation addresses any safety or health hazards first. Additionally, the renovation funds will be kept in an escrow account paid directly to contractors as they complete the work.
Lower-Priced Houses with Less Competition
Forget the real estate open houses that smell like freshly baked cookies—if you’re shopping with a 203(k) loan, you’re on the hunt for those underdog properties. Most homebuyers want move-in-ready homes, so looking for a diamond in the rough will net you fewer competing bidders and more negotiation potential with sellers.
Cons of an FHA 203(k) Loan
Though there are many benefits of an FHA 203(k) loan, it’s not a one-size-fits-all solution. Let’s take a look at why this solution doesn’t fit every home selling or buying requirement.
More Time and Paperwork
If you’re in a hurry, a 203(k) loan may not be for you. The average length to closings in 2021 was 57 days for a conventional mortgage and 62 days for an FHA loan.3However, that 62-day figure reflects all FHA loans; if you’re closing with a 203(k) renovation loan, experts say to plan on between 60 to 90 days.
Remember: You’re not just closing on a property; you’re submitting a renovation plan and detailed contractor bids, which often require back-and-forth with multiple parties.
Limits on Use of Funds
You’ve borrowed it, and you’ll be paying it back for years with interest, but it’s not money you control free and clear. The funds targeted for renovation must be used exactly as planned.
That means 203(k) funds cannot pay for things like:2
- Luxury upgrades such as pool, tennis court, or outdoor gathering spaces
- Furniture or any non-permanent changes to the house
- Minor landscaping not denoted in the project plans
- Projects that take longer than six months
Mortgage Insurance Premiums
Private mortgage insurance (PMI) protects the lender’s investment but is paid out of your pocket. With a conventional mortgage, you can avoid this entirely with a down payment of 20%. Otherwise, you’ll pay it until your principal repayments hit 22% equity.
Instead of temporary PMI, FHA loans require you to pay a mortgage insurance premium (MIP) in one of two ways:1
- Closing cost MIP of 1.75% of the total loan amount
- Annual MIP of 0.45% – 1.05% for the life of the loan (paid monthly).
Limited Pool of Contractors
The paperwork doesn’t stop with you; 203(k) loans include forms and steps for contractors to take outside of their normal process in order to get paid. Plus, lenders can send back bids multiple times for changes or clarifications.
Unless you work with a contractor who has previous successful FHA experience, you can end up with contractors who refuse to meet lender demands or walk away before the job is completed.
Lack of DIY Allowance
Unless you’re a licensed, insured contractor, don’t plan on doing any of the remodeling work yourself. Renovations must be completed by the approved contractor per the bid that accompanied your appraisal and loan approval.
Choosing the Right FHA 203(k) Loan Provider
As with any loan process, be sure to shop around and compare rates and terms before selecting a lender to work with. For an FHA 203(k) renovation loan, be sure to ask about the amount of experience the lender has granting this type of loan, and inquire about the credentials of their loan officer or mortgage broker as well.
Since the FHA allows for more flexibility in its borrower requirements, skilled providers will know that many guidelines allow for exceptions based on extenuating circumstances and the use of letters of explanation (LOE) to supplement an application that may otherwise be denied at the underwriting stage. This may help you avoid running into a situation where you have a pre approved FHA loan then denied.
Residential Sale-Leasebacks: A Different Option
If you’re considering a 203(k) renovation loan to fund home repairs or modifications, have you investigated all your options? FHA loans, home equity loans, cash-out refinancing—these options can all lead to more debt. But a residential sale-leaseback program can offer cash upfront for your home that you can use to fund renovation projects.
With average 30-year fixed interest rates rising above 7.0% recently for the first time since 2002,4 taking out a new mortgage may not be the most financially strategic choice. If your goals are to stay in your home and free up funds for renovation, a sale-leaseback program can offer:
- 100% of your home equity converted to cash
- The legal right to remain in your home as long as you wish
- No more property tax, homeowner’s insurance, or private mortgage insurance costs
- Someone else covering the work and cost of major repairs and covered maintenance
FHA 203(k) renovation loans are useful tools that allow more potential and current homeowners—particularly those with less-than-ideal financial situations—to renovate their home. An FHA 203(k) loan allows homeowners to streamline their funding needs into a single loan, build home equity quickly, borrow with a smaller down payment, and receive guidance in the home improvement process.
On the other hand, FHA 203(k) loans can create a slower closing process, more paperwork, renovation limitations, and extra fees for mortgage insurance. If you’re looking to free up funds without taking on new debt, consider these FHA 203(k) loan pros and cons and inquire with an experienced residential sale-leaseback provider to determine if it meets your needs.
- JP Morgan Chase & Co. How to qualify for an FHA loan. https://www.chase.com/personal/mortgage/education/financing-a-home/how-to-qualify-for-fha-loan
- NerdWallet. What Is an FHA 203(k) Loan? https://www.nerdwallet.com/article/mortgages/fha-203(k)-renovation-loan/
- Investopedia. How Long Does It Take to Close a Mortgage? Time Line to Close. https://www.investopedia.com/how-long-to-close-mortgage-5224962
- FRED. 30-Year Fixed Rate Mortgage Average in the United States. https://fred.stlouisfed.org/series/MORTGAGE30US