How do home modification loans work?
The Federal Housing Administration offers a loan that allows borrowers to modify or renovate the home they are looking to purchase, or to refinance the one they already own.
An FHA-insured Section 203(k) loan allows borrowers to lump the cost of repairs and improvements into their mortgage. Some areas of the country have housing that is outdated and in need of repairs, so this particular loan has gained significant popularity in recent years.
The 203(k) loan also can be a good refinance option for homeowners who either cannot or do not want to tap their home equity.
There are two types of 203(k) loans. A streamlined or limited 203(k) has an easier application process, and the repairs or improvements must total $35,000 or less. The standard 203(k) requires additional paperwork and applies to improvements costing more than $35,000. Either type of 203(k) loan requires a minimum of $5,000 to be spent on rehabilitation of the home. Generally, the maximum mortgage amount is the lowest of:
-The FHA’s maximum mortgage limit for the area.
-A calculation involving the home’s “before” value plus improvement costs.
-A calculation involving the home’s “after” value, including the improvement.
While 203(k) loans can be used for refinancing as well as purchase loans, they are limited to owner/occupants. Investors are not eligible.
A limited 203(k) has an easier application process and the repairs or improvements must total $35,000 or less. The standard 203(k) requires additional paperwork and applies to improvements costing more than $35,000. Both types require a minimum of $5,000 to be spent on renovations or repairs.
This type of loan comes with an extra set of rules. The work must begin within 30 days of closing and be completed within six months. The borrower is allowed to be named the contractor if qualified, but cannot be paid for anything outside the cost of materials and must meet specific FHA qualifications. If you hire a contractor, be sure to ask if they have done 203(k) program work before. The contractor needs to understand the payment schedule and requirements. When work is complete, the borrower provides a letter, and a HUD-approved cost consultant conducts an evaluation. Consultants can be found through a lender or via the FHA website.
You should know that certain types of projects are ineligible for 203(k) financing, and the restrictions differ for which type you have. For example, with a streamlined 203(k) you can repair the roof or fix the plumbing, but you can’t do major structural repairs like putting on a new addition or fixing a cracked foundation. Standard 203(k) loans allow almost any home improvement as long as it adds value to the home. This includes major structural repairs, but not luxury items like a swimming pool.
Like all FHA loans, 203(k) mortgages allow you to make a down payment of as little as 3.5 percent. That’s based on the total loan amount, including both purchase and renovation costs. Interest rates on 203(k) loans are slightly higher than other FHA loans because there’s a greater risk for the lender until the work is actually completed on the property. You will also need a slightly higher credit score, somewhere around 580 or better. The loans require an upfront mortgage insurance payment of 1.75 percent of the total loan amount, which can be wrapped into the financing. Borrowers also pay a monthly mortgage insurance premium based on the loan-to-value ratio and length of the mortgage.
Even though the terms are a bit tougher than a standard FHA loan, it works great for the homebuyer dead-set on turning a fixer-upper into a dream home.