The FHA 203k loan helps individuals and families belonging to the lowest income brackets[1] buy a house in a bad physical condition and renovate it as their primary residence.

The FHA 203k loan plays a key role in breaking down many barriers to homeownership in the United States.

Generally, individuals who do not make a lot of money struggle to qualify for conventional loans[2]. The backing of the federal government, particularly the FHA, helps quell lenders’ worries when dealing with such mortgage borrowers.

However, unlike other government-insured loan programs, the FHA 203k loan is issued by FHA-approved lenders[3] only. The FHA does not offer this loan program directly to borrowers but merely insures it.

What Are the Pros and Cons of a 203k Loan?

FHA 203k loans have clear advantages over standard mortgages, such as:

• Single Application. Taking out an FHA 203k loan eliminates the need to apply for a mortgage and a home improvement loan separately. This dual-purpose loan can have a weaker negative effect on credit scores than the impact of two individual loans[4]. Plus, the overall cost of an FHA 203k loan is typically less than the sum of all fees of multiple loans.
• Favorable Interest. FHA-approved lenders may offer lower fixed or adjustable interest rates than banks and credit unions that only do conventional home loans.
• Minimal Down Payment. With the FHA 203k loan, a borrower with relatively good credit can put down as low as 3.5%. One whose credit score is anywhere between 580 and 499 has to come up with a 10% down payment, though. Nevertheless, an eligible and approved FHA 203k borrower does not have to think about the unwritten 20% rule[5] and can pay less out of pocket to close the deal.

On the other hand, it also has several disadvantages that borrowers should be aware of, including:

• Unavoidable Mortgage Insurance. A borrower has to pay FHA mortgage insurance[6] that has an upfront premium of 1.75% of the loan amount. The borrower can add it to the closing costs[7] or roll it into the loan. Also, there are monthly premiums, ranging from 0.45% to 1.05%, which they have to pay for at least the loan’s first 11 years.
• Tons of Paperwork. Since the FHA 203k is essentially a construction loan, the borrower may have to use an independent consultant to prepare a detailed renovation proposal and a list of cost estimates for all items.
• Tedious Process. The FHA 203k loan application process can be lengthy and not just because of the additional required documents. The borrower must need the approval of the FHA and an FHA-approved lender too.
• Uncompensated Labor. A borrower with a handyman license[8] can personally do repairs to reduce the loan amount. However, the borrower cannot hire themselves for the renovation project. In other words, any DIY improvement done is purely sweat equity[9].

As an FHA loan, this program has more lenient requirements than conventional mortgages. Nevertheless, it involves a rigorous vetting procedure. The following are common reasons why borrowers get denied:

• Failing to Provide Proof of Employment. One must be employed for the last two years before applying and presenting verifiable documents to prove it.
• Carrying Too Much Debt. The FHA 203k loan requires a debt-to-income (DTI) ratio[10] of 43%. Borrowers with a relatively high credit score and plenty of cash reserves[11] may be allowed to have a DTI ratio as high as 50%.
• Not Meeting the Minimum Credit Score Requirement. The lowest credit score one must have to apply for the FHA 203k loan is 500. That said, many participating lenders require at least 600.
• Lacking Sufficient Funds to Put Down. Saving for a mortgage down payment is always a difficult proposition. Borrowers are advised to take advantage of monetary gifts[12] from family, friends, and charitable organizations to cover up to 100% of the FHA 203k loan’s minimum down payment requirement. A borrower should strongly consider state-sponsored assistance programs[13] as well.
• Choosing the Wrong Property. The FHA 203k loan limits property options to preexisting one-to-four-family home units, manufactured homes, and condominiums at least a year old. Also, one’s chosen property cannot be a co-op[14].
• Borrowing More Money Than Allowed. Selecting a property whose selling price and total renovation cost exceed the local FHA 203k loan limit guarantees the rejection of the application.
• Proposing an Ineligible Improvement. The FHA 203k loan is a good source of funding to bring a beat-up house up to code. But it does not cover luxury home improvements[15].
• Experiencing a Recent Foreclosure. Any borrower that has a record of foreclosure in the last three years is unlikely to get approved.

Two factors decide how much one can borrow using the FHA 203k loan: the property’s location and the extent of its damage.

The maximum FHA loan varies by location. In general, the highest amount one can borrow in a low-cost county is $356,362, whereas the cap goes up to $822,375 in a high-cost area[16].

Furthermore, the habitability of a borrower’s chosen property determines whether they can qualify for the limited 203k or the standard (or streamlined) 203k.

The limited 203k applies to houses that need minimal work and caps the budget for cosmetic repairs at $3,000. On the other hand, the standard 203k is for houses that require extensive work, including structural improvements, to reach a liveable condition and sets the minimum amount for renovations at $5,000.

The FHA-approved lender may withhold up to 20%[17] of the borrowed amount for improvements to cover any unexpected expenses. A contingency reserve is required on the standard 203k but not on the limited 203k.

Lastly, the standard 203k may also include funds for temporary housing if the borrower has to live elsewhere and rent while the house is under rehabilitation. The limited 203k does not have this feature since it requires the property to be habitable while being repaired.

• The FHA 203k loan rolls a mortgage and a renovation loan into one.
• An FHA-approved 203k lender extends credit to low- and moderate-income individuals who want to buy a house in bad repair as a primary residence and get it renovated.
• The FHA 203k loan requires a low down payment and may come with favorable interest rates, but it has its share of drawbacks, including unavoidable mortgage insurance and tons of paperwork.
• The property’s location and extent of damage determine the maximum amount one can borrow using the FHA 203k loan.

1. Snider, S. (2020.) Where Do I Fall in the American Economic Class System? U.S. News. Retrieved from https://money.usnews.com/money/personal-finance/family-finance/articles/where-do-i-fall-in-the-american-economic-class-system
2. Luthi, B. (2019.) What Is a Conventional Loan? Experian. Retrieved from https://www.experian.com/blogs/ask-experian/what-is-a-conventional-loan/
3. Hernandez, K. (2016.) FHA-Approved Mortgage Lenders. SF Gate. Retrieved from https://homeguides.sfgate.com/fhaapproved-mortgage-lenders-51243.html
4. Daly, L. (2019.) 7 Reasons for Your Credit Score Drop (and How to Fix It). The Ascent. Retrieved from https://www.fool.com/the-ascent/banks/articles/7-reasons-for-credit-score-drop-how-to-fix-it/
5. Zillow. (2020.) Why Is 20% Ideal for a Down Payment? Retrieved from https://www.zillow.com/mortgage-learning/20-percent-down-payment/
6. NerdWallet. (2021.) FHA Mortgage Insurance. Retrieved from https://www.nerdwallet.com/article/mortgages/fha-mortgage-insurance
7. Ceizyk, D. (2020.) How Much are FHA Loan Closing Costs? LendingTree. Retrieved from https://www.lendingtree.com/home/mortgage/fha-loan-closing-costs/
8. Next Insurance, Inc. (2021.) Handyman license requirements by state: A comprehensive guide. Retrieved from https://www.nextinsurance.com/blog/handyman-license-requirements/
9. Corporate Finance Institute. (2019.) What is Sweat Equity? Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/valuation/sweat-equity/
10. Wells Fargo. (n.d.) What is a Good Debt-to-Income Ratio? Retrieved from https://www.wellsfargo.com/goals-credit/smarter-credit/credit-101/debt-to-income-ratio/understanding-dti
11. The Truth About Mortgage. (2021.) Asset and Reserve Requirements for Mortgages: How Much Money Do You Need? Retrieved from https://www.thetruthaboutmortgage.com/assets-and-reserve-requirements/
12. Chase. (n.d.) How to use gift money for a down payment. Retrieved from https://www.chase.com/personal/mortgage/education/financing-a-home/gift-money-for-down-payment
13. Johnson, J. (2021.) First-Time Homebuyer Grants and Programs for 2021. Crediful. Retrieved from https://www.crediful.com/first-time-homebuyer-grants/
14. Mandell, L. (2021.) What Is a Co-op? A Home You Don’t Technically Own. realtor.com®. Retrieved from https://www.realtor.com/advice/buy/what-is-a-co-op/
15. John, S. (2021.) Expensive Home Upgrades That Are Actually Worth the Money. We Heart. Retrieved from https://www.we-heart.com/2021/06/18/expensive-home-upgrades-actually-worth-the-money/
16. Residential Mortgage Services. (n.d.) Is an FHA 203k Renovation loan for you? Retrieved from https://rmsmortgage.com/blog/2020/01/10/is-an-fha-203k-loan-for-you
17. Ott, J. (2020.) 10 Things to Do for a Smooth Renovation. Houzz. Retrieved from https://www.houzz.com/magazine/10-things-to-do-for-a-smooth-renovation-stsetivw-vs~115268405