Under normal circumstances, lenders will not provide mortgages for homes that are not habitable. Buying a home and fixing it up, often requires a three-step funding process. A homeowner has to find funds to purchase the property and obtain additional financing for the repairs.[1]  Then, once the project is complete, the homeowner can apply for a long-term mortgage to repay the previous debts. [2]

203(k) is a federal program designed to encourage lending for homes that require renovation or rehabilitation.[3]  The program, which is designed strictly for homeowners, simplifies the process by allowing individuals to start out with a single long-term loan that includes funds to purchase or refinance a property and to fix it up.[4]

Though the loans are issued by private lenders, the Federal Housing Administration (FHA) insures the mortgages to minimize the lenders’ risks and encourage participation.[5]

Loans and Eligible Properties

Two types of loans are available under the program.[6]  A regular, or full, 203(k) loan is provided for homes that need structural work, such as adding a room or converting a multi-family dwelling into a single-family dwelling.[7]

For a regular 203(k) loan, the planned rehab project must cost at least $5,000.[8]  The maximum loan amount for homes purchases will be the lesser of the as-is value or purchase price of the property plus repair costs, or 110 percent of the estimated value of the property after the planned improvements.[9]

A streamline 203(k) loan allows a homeowner to finance up to $35,000 for a property where no structural work is required.[10]  The money can be used for cosmetic improvements, such as painting, updating appliances and installing new carpet, and the loan is not subject to a project cost minimum.[11]

203(k) loans are available for a broad range of properties, including one to four family dwellings, condos and the residential portions of mixed-use properties.[12]  A borrower can even get a 203(k) loan to purchase a property, tear down the existing structure and move another dwelling to the site, as long as the existing foundation is left in tact on the mortgaged property.[13]

Generally, a dwelling must be at least one year old, but that rule does not apply in a federal disaster area, says Ray Brousseau, Executive Vice President of Carrington Mortgage Services.[14] This makes  203(k) loans a good tool for those looking for assistance in areas stuck by natural disasters, he explained in press release.[15]

Pursuing a 203(k) Loan While Assessing the Costs

With 203(k), qualified borrowers can get 30-year financing with just 3.5 percent down, Brousseau says.

These terms may sound attractive, but borrowers should be forewarned that the loan process is often lengthy and complicated and there is a possibility that borrowers will ultimately need larger loans than they initially expected. This is especially if they take advantage of opportunities to bundle additional costs into the mortgage.

For example, many borrowers find it necessary to hire a consultant to meet the requirements for architectural exhibits and detailed cost estimates. These consulting fees can be added to the loan. A borrower may also include up six months of mortgage payments to cover the period when the home is being repaired.

Additional loan amounts may also be required to comply with local zoning codes and FHA minimum requirements, such as energy efficiency standards.[16]  Lenders may impose additional standards for the rehab project and require a 20 percent contingency reserve to guarantee adequate funds in case actual project costs exceed the cost estimates.[17]

The ability to purchase a home and build a dream while bundling the associated costs into the mortgage may seem ideal, but homeowners who ignore the financial details risk over-investing in a project and having a home too expensive for resale.[18]

203(k) loans may be convenient, but they are not guaranteed to be cheap. Even with government insurance, lenders still view rehab loans as riskier than a traditional mortgage.[19]  Risk tends to warrant higher interest rates, which are not government regulated, but rather left to negotiation between the lender and the 203(k) loan applicant.