Finance a Fixer Upper House With an FHA 203(K) Program

The astronomical housing prices in many areas can make home buying a frustrating experience. Buyers on a budget may find they have a choice between houses that are too small for their needs or rundown dumps. Among the latter, however, are a great many housing nightmares that could be turned into dream homes with a bit of work. Even if you don't do any of the work yourself, you can often buy a fixer-upper and rehabilitate it for quite a bit less than you would spend on a comparable house in "perfect" condition. Paying for the house and the repairs, however, can be a bit tricky, as many lenders won't finance a house that needs a lot of work. Fortunately, the U.S. Federal Housing Administration (FHA)--a division of the Department of Housing and Urban Development (HUD)--has the Section 203(k) program, a mortgage insurance program specially tailored for this situation. While this article focuses on how to use the program to purchase a home, 203(k) loans can also be used to refinance your existing mortgage in order to rehabilitate a house you already own.

Steps

  1. Determine how much house you can afford. Current 203(K) loan programs are 3.5% down, so a $200,000.00 home will be $7,000.00 down. Talk to a lender to see what loan amount you can be approved for based on your income and expenses. Most importantly, figure out yourself how much you can realistically afford. It's not uncommon to be approved for a loan that will stretch your budget to the point of foreclosure.
  2. Find a house with potential. Look for a house you like in a neighborhood you like. The 203(k) program currently cannot be used by investors, so you'll need to live in the house (or be a qualified non-profit agency). Together with your real estate agent, perform a preliminary feasibility analysis, in which you identify the repairs necessary, estimate the cost of these repairs, and estimate the market value of the home after the repairs. You can save yourself some money by doing this before you order appraisals or estimates, since you may determine that the cost of repairs is too high.
  3. Execute a contract for the sale of the home. In order to proceed with the 203(k) application process, you'll need a sales contract with a clause stating that the sale is contingent on your ability to obtain financing through the program.
  4. I always ask the seller to pay the closing costs and this can really lower the money you need to finish the purchase. This is perfectly OK with HUD.
  5. Apply for the loan. Contact a HUD-approved lender to apply for the loan. You can obtain a list of approved lenders at the nearest HUD field office or on HUD's website. Some loan officers will not want to do the extra paperwork so don't accept a "NO". These loans are being approved every work day of the year.
  6. Get an estimate of how much the work will cost. The amount of a 203(k) loan cannot be increased during construction, so it's essential to get an accurate estimate of how much the work will cost. For fastest results, get an estimate from a HUD-approved contractor or fee consultant. You can find approved consultants on HUD's website.
  7. Get an appraisal. Actually, the lender orders the appraisal based on the hypothetical assumption that all the repairs are completed based on the specification of repairs completed by the HUD approved Consultant or a licensed contractor if the scope of work is cosmetic in nature and doesn't exceed $35,000 (streamline FHA 203(k)). The loan amount is based on the lesser of the home in its existing condition plus the cost of repairs or 110% of the estimated value of the home after repairs. The amount of the loan is also subject to maximum FHA mortgage limits, which vary per County and State.
  8. Find a contractor. The 203(k) program requires that the repairs be performed by a qualified contractor. Most people opt to hire a licensed contractor (typically the one from which they got the estimate), but if you're qualified to do the work you can save yourself some money by doing it yourself. Keep in mind, however that you can only be paid for materials if you're doing the work yourself. If this ends up costing less than the contractor's estimate, the excess money can be used for additional improvements or it will be applied to the principal of the loan. Also make sure that you'll be able to complete the repairs within the maximum allotted 6 months after the purchase. If you won't be able to complete the repairs yourself, hire a contractor, such as a certified 203K contractor. HUD does not recommend or certify contractors; When choosing a contractor, it's best to get a referral from friends, family members or local real estate agents or investors in your area. Make sure you get 2-3 references from the contractor and be sure to call the homeowners and call or visit the properties they are currently working on and ones that have been completed for a year or more. A good contractor will make the remodel a great experience, make sure you hire a good contractor by asking the right questions, seeing their work and talking to their past customers.
  9. Close on the home. If everything is approved, you can purchase the home with as little as 3% down. If you're unable to occupy the home immediately, you can use the extra six months of mortgage payments which may be included in your loan to pay the mortgage while you're also paying to live elsewhere.
  10. Make sure to get the work done on time. You have six months after the purchase in which to complete the repairs. The repair fund is held in escrow and is disbursed in installments to the contractor (or to you, if you're doing the work yourself). A HUD-approved inspector must review the progress before each disbursement is made.
  11. Get a final inspection. Once work is completed according to the initial plans, get the final inspection. If there is money left over, it must be applied toward the principal of the loan.

Tips

  • The program allows borrowers who are qualified to do the work themselves to provide their own cost estimate for the repairs. The estimate must be the same as one you would get from a contractor, however, and the HUD process for doing the estimate yourself takes several months (as opposed to a couple weeks for an independent consultant), so you're better off having a fee consultant or contractor provide the estimate, even if you plan on doing the work yourself.
  • Even with the best planning and estimates, major home remodeling or rehab almost always costs more than you expect. As a rule of thumb, add 10% to whatever your estimated cost is. 203(k) loans require at least a 10% contingency reserve for such unexpected expenses.
  • The minimum repair amount necessary is $5,000. Beyond this, a wide variety of repairs are eligible for the loan, including energy conservation and renewable energy upgrades and even moving an existing house onto the foundation of a home you intend to demolish.
  • The 203(k) program is not for everybody. For example, if you're solely looking to invest in the home and then "flip" it, you won't qualify, and you also won't qualify if the cost of the house plus repairs exceeds HUD's maximum mortgage limit in your area. If this is the case, there are some other options, including Fannie Mae's Homestyle loan and home equity loans on your existing home. A few private lenders also offer programs for these "handyman specials," but they have their own, often stringent, qualifying standards.
  • The market value of a home depends largely on its location, so it's usually best to find a fixer-upper home in a desirable location, rather than one in an area with a depressed housing market.
  • Once work is completed the 203(k) mortgage is eligible to be refinanced as an FHA 203(b) loan, which may result in lower payments.

Warnings

  • Don't bite off more than you can chew. Be sure that you can get the work done within the time limits set by the terms of the loan. If you don't, you may not receive the remaining repair proceeds and the loan could be payable immediately.
  • Keep in mind that individual lenders are allowed to make certain stipulations that vary from the guidelines set forth here. For example, they may require that the work be performed in less than six months.
  • This article is a general guide only and is not intended to replace professional financial or legal advice.

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