Any time you can find a government program that excludes investors and is only limited to occupants or users, the odds are good that the terms are relatively advantageous. This is the case with FHA 203k home improvement loans, which provides an opportunity for home-buyers to receive a mortgage that also covers the cost of future/current home repairs as part of the initial loan that you receive.
If a homebuyer is looking to purchase a $250,000 property, but sees that the kitchen has not been updated since the 1970s and will need $30,000 in repairs, an FHA 203k loan can give you a single loan that consolidates both the home purchase and the improvement into a single loan.
There are six important factors to weigh when thinking about a 203k loan.
First, the total amount that can be borrower under this FHA provision is 110% of the home’s purchase value. In this case, if the home value is $250,000, the total amount that can borrowed is $275,000.
This provision has to be read with the requirement to make a down payment of at least 3.5% on any FHA-eligible loan. As a result, this hypothetical scenario would require a down payment of $8,750.
The math would work as follows: $8,750 down payment plus $241,250 mortgage plus $30,000 kitchen repair will give you $271,250 in total borrowings which falls below the $275,000 maximum that you could borrow under this scenario.
The reason why 203k loans are attractive is that the total cost of the home improvement is only about one percentage point above your mortgage rate. If your interest rate is 5% for the $241,250 mortgage, it should only be around 6% for the home improvement. With traditional lending, the interest rate for a home improvement is typically three to five percentage points higher–without government assistance, the free market would charge you 8-10% interest on the home repair portion.
Attractive interest rates are the reason why the Federal Housing Administration only permits these deals to homebuyers and not investors.
The other catch is that the home improvement cannot be used for a luxury renovation (e.g. you can have the 203k loan cover the cost of filling in a pool, but you can’t have it cover the cost of installing a pool). Kitchens, disability access, and bedroom additions to match the children living in the house are the most typical uses of 203k loans. Improvements to address drainage issues are also permitted.
The other catch is that receiving approval can be somewhat difficult, as 70% of approved borrowers for this FHA program have a credit score of 680 or above. The other 20% have scores in the 640 to 679 range. If your credit score is below 640, obtaining an FHA 203k loan is almost impossible, which may not be the worst thing anyway since your own baseline interest rate would probably be in the 7-8% range when your credit rate is that low and you wouldn’t want to be carrying an unusually high debt burden.
The final downside is that the contractor must be informed that the improvement work is the result of an FHA loan, and this will require the contractor to fill out paperwork proving their certification and licensing to comply with FHA-eligibility status. This can make it difficult to negotiate advantageous deals with contractors–though if you are planning on spending $25,000+ on repairs, contractors tend to work with you (minor home improvements in the $2,500-$5,000 range that are FHA-funded may involve difficulty in getting a bargain from a contractor because they won’t want to fiddle with compliance when the payoff for the work is minimal.)
FHA 203k loans are most appropriate for homebuyers that find a place they are planning to live for at least a decade and are buying a house that is well-updated in nearly all regards except for a kitchen. Because dated kitchens diminish home value more than nearly other neglected room, it is possible that you will receive $0.85 on the dollar in terms of increased appraisal value that follows the improvement, and the interest rate on these programs is close to the rate you’d be paying on the mortgage itself. Once interest rates increase another two percentage points, the high principal balances of a 203k loan won’t make much sense to consider.