About a month ago, the vacant house two lots north of me finally sold after being on the market for six months and sitting empty for (my neighbor estimates) about 20 years. That little time capsule was in great shape, but it was super outdated — it didn’t even have central heat and air, which is almost a necessity where I live. When the new owners did finally close, I noticed that they didn’t move in right away, instead they had a guy out to install a new HVAC system and, presumably, an electrical system update.
Why am I telling you this? Well, those kids are first time homeowners and they bought their house using a product called an FHA 203(k) mortgage. It’s a super cool thing that most people don’t even realize is a thing — and I wanted to tell you all about it before you got hot and heavy in looking for a new home this year.
With an FHA 203(k), you can buy that house that’s desperately in need of repairs, with some caveats. So if you find the perfect house and it’s at an insanely low price because no one is brave enough to tackle the roof problem or the leaky basement or whatever’s going on with it, don’t feel like you have to turn back — move forward boldly with an FHA 203(k).
How the FHA 203(k) Mortgage Works
Normally, when you’re getting an FHA loan, you’re going for one of the traditional ones (known as FHA 203(b), in case you were curious). This is the default when you ask for an “FHA mortgage.” They’re very different beasts from the FHA 203(k) because they’re created to be used only on homes that fail the FHA habitability test.
The minimum property standards can seem pretty major when you’re hoping to save some money by buying an older home or one in need of what feels like relatively minor repair. Typical pain points for standard FHA loans are heating units with busted heat exchangers, houses that lack heat in every room, roofs with very little life remaining, major plumbing issues, ancient electrical systems and so forth.
Because these items can end up being very expensive, FHA doesn’t want to insure the loan since it’s likely you could default over trying to juggle paying for them and still keeping your mortgage current. Instead, they simply won’t approve standard FHA loans without these items being repaired…and that’s where so many people looking for a house that needs a little something get into trouble. FHA, like you, isn’t in the habit of dealing with homes that need remodeling and often underestimate what it’s going to cost to make these sorts of repairs. It’s scary for FHA and it’s scary for the lenders doing the underwriting. So they don’t write it and you end up back at square one.
That’s where the FHA 203(k) mortgage strays from its FHA roots. Instead of limiting what can be wrong with the property, it requires your future property come with necessary repairs. The minimum estimated cost is $5,000 — but depending on where you live, that can easily be the price of an electrical system upgrade or an HVAC system with all new ductwork. Of course, this doesn’t come with zero strings, so it’s not necessarily the perfect option for everybody.
The Catch With FHA 203(k) Mortgages
FHA 203(k)s sound great for someone who wants to get their hands dirty doing some home improvement while saving a bundle on their mortgage. They sound like a dream, in fact. And for some people they are, but they’re not exactly what you think. An FHA 203(k) isn’t an open ticket for you to do what you will and forget the consequences. It’s not for the DIYer who will try to DIY as much as possible.
Instead, when you elect to do an FHA 203(k), you’ll be paired with a 203(k) Consultant who will help you prepare a write-up for the bank explaining the work you intend to do to your property with your home improvement mortgage. Even if you don’t care for this part of the process, it’s actually very good for both you and your home. The consultant is experienced enough to be able to tell you if what you intend to do will involve a great deal more than you think. For example, when my neighbors updated that HVAC system, it probably required they updated the electrical, too. Many home buyers don’t realize there’s a minimum size electrical service for things like central air conditioners.
That’s the role of the consultant, to keep you from making huge mistakes that can be incredibly costly. They’ll also tell you if the plans you have are feasible. A good example of this is something you see on HGTV all the time: knocking out walls. You may think you can open the kitchen up in your future home by knocking out the wall between the kitchen and the dining room, but your consultant will tell you if there’s something that would make that extra complicated, like an old chimney flue in the wall or the wall being load-bearing. Extra complicated means extra costly and, sometimes, cost-prohibitive.
The catch doesn’t stop with the consultant. You’ll need contractors to provide you with written bids for the work that your home will need and all of that information will have to be delivered to your lender. Only then will your lender decide to approve your plan, or not. In this way, an FHA 203(k) functions very much like a construction loan. If the improvements you want to make to your future home will both improve the value and the habitability of the property, you’re likely to get the green light. Some examples of that include:
- Replacing aging systems like an old roof or HVAC.
- Installing energy-efficient appliances and plumbing fixtures.
- Stabilizing the foundation or correcting other structural issues.
- Updating windows from single pane glass to thermopane.
- Upgrading siding to a modern standard typical for your area.
- Rebuilding rotting decks or crumbling porches.
This is only a short list, there are likely many other things that most lenders would consider, but the thing I’m trying to emphasize is that your lender is focused on making the house better in a big way. They’re not likely to want to help you with cosmetic upgrades that do nothing but change the way your property looks. So if the formica in the kitchen is in good shape, just uglier than sin, chances are good that an upgrade won’t be approved. If it’s damaged, though, go for it. The worst thing they can do is say no. Above all else, take the advice of your consultant. They’ve done a lot of these write-ups and know what will fly and what won’t.
Great! How Do I Pay for Those Repairs?
Once you’ve closed on your loan, the real fun begins. You get to pretend like you’re a general contractor. Hooray! GCs generally pay their people using draws — this is a written request for a loan distribution from a title company or other financial guardian. Your lender will tell you what institution will handle your draws, so pay attention.
Your actual contractors will want to get paid at some point, so with their portion of the work complete (or at predefined stages, depending on the scope of the project), you’ll complete a draw and call your consultant. They’ll come out and take a look at the work that has been done to make sure it’s up to snuff and no corners were cut. If all checks out, your consultant will sign the draw request and you can submit it. The lender then cuts a check for the contractor on your behalf. Simple? Yes!
When all the work you requested is finished and your consultant has inspected it, you’ll need to provide a release letter to the company handling your funds. It should specify that the work is completed to your satisfaction and give permission to release the remaining funds. Now you’re done and you can move into the masterpiece you helped to create.
With this program, the contractor does not get upfront money. It protects the contractor money and doesn’t pay out until the work is underway. Make sure you choose a lender who will release contractor funds on time.
Acting As Your Own Contractor
In a few instances, you may be permitted to act as your own contractor. You’ll have to be able to demonstrate your experience and ability in the construction field. So, for example, if your parents own a construction company and you’ve worked there for years as a General Contractor, that might fly. Working in the construction field may also be acceptable, depending on what type of work you currently do and what jobs you think you can handle in your new home.
If the lender approves you working as your own contractor, they’ll require an additional form called a “Self-Help Agreement.” You’ll also be required to provide receipts for materials or services you’ve paid for out of pocket and lien waivers from any subcontractors you hire to help with your portion of the work. It’s super important that you stay organized. Even though you only have one project, the mound of receipts can be pretty impressively tall if more than one small thing is being repaired.
FHA 203(k) is Also Possible on a Refinance
If you’ve already gotten your loan, but found you need to make repairs well above and beyond what you expected, you may be able to refinance into an FHA 203(k). These are called Streamline FHA 203(k) mortgages — they’re very similar to the full blown FHA 203(k), with one main exception. The types of repairs they allow are much more limited, but can include replacing or upgrading roofs, HVAC or appliances, non-structural home repairs, weatherization, lead-based paint abatement, deck repair and modifications for disabled homeowners.
Repairs for this type of loan are capped at $35,000 in value and the use of self-help is highly discouraged. The repairs requested should not be things that would put you out of your home, like foundation repair. These loans carry the same sort of rules as a standard FHA refinance, so you may end up with PMI even if your old loan didn’t have it — check with your lender before proceeding.
The Bottom Line: FHA 203(k) Mortgages are Under Utilized and Super Cool
Even though you lose some control over what repairs will be made on your home, ultimately, an FHA 203(k) mortgage is a really cool deal for a lot of young homeowners. Instead of having to buy a home that’s ready to go and costs and arm and a leg, you can seek out an older house in a well-established neighborhood and bring it up to modern standards.
I know this sounds like you have to pick a real ancient house, but that’s not really the case. Any house that needs a roof, updated HVAC or new siding might be eligible, depending on the extent of the necessary repairs. You’ll be surprised at the homes this type of mortgage opens up for you — some might even feel perfect the way they are (once the new roof is installed!).
My neighbors picked up a little gem with nice cherry-stained oak cabinets, hardwood floors and big windows for a song with their FHA 203(k). It had a floor furnace, which scared off a lot of buyers — but the savvy ones knew it was only a minor stumbling block. If you want your own project home, this is definitely the way to go. With a pro to guide you, you can be sure your plans aren’t going to make a bigger headache than you were prepared for, as well.