What Is a Rehab Loan?

Written By Cathy Lovering
Last updated May 24, 2021

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Loans
May 24, 2021

Simple. Thrifty. Living.

A rehab loan lets buyers finance a home that’s less than ideal in terms of condition. Often, it may be the only way new buyers can enter the housing market. Homes within their price range may need extensive renovations and may not qualify for a regular mortgage.

A rehab loan rolls the cost of renovations and purchase price of a home into a single mortgage. The FHA insures these loans with its 203(k) rehab mortgage insurance.

According to HUD, the intent of these loans is to help people finance homes while providing security for lenders.

A 203(k) loan offers affordability for buyers. It gives them an alternative to the high-interest, short-term acquisition and improvement loans that often come with costly balloon payments. Meanwhile, the government-issued insurance provides a safety net for lenders who can’t assess the property condition before approving the loan.

Rehab loans are pretty rare. There’s a lot of extra paperwork. Some lenders may not know enough about them to help you through the process, so it might take some shopping around to find one. But if you can get past the red tape, a rehab loan can be your path to homeownership or a quality investment.

Once funding has approval, the proceeds of the loan go first to the seller. In the case of a refinanced property, the loan pays off the existing mortgage. The remaining funds go into an escrow account and are available for renovations. A rehab loan must come from an FHA-approved lender.

There are two types of 203(k) loans. The one you choose depends on how much you need for renovations and the kinds of repairs you make.

Standard 203(k) Mortgage

The standard loan covers structural repairs and nonstructural repairs. There are several factors to note:

  • Your repairs must cost at least $5,000
  • You must hire a HUD consultant to oversee renovations
  • You can do the labor yourself, but you cannot pay yourself for that labor

Your renovations could still go over budget. If your mortgage isn’t enough to cover them, you’ll need to pay the difference out of pocket.

Limited 203(k) Mortgage

The limited loan is for homeowners whose property needs minimal work. The renovation portion of the mortgage cannot exceed $35,000. You do not have to hire a HUD consultant, but there are some other conditions:

  • You must create a work plan before you apply for the mortgage
  • Your work plan must include itemized cost estimates, and you may have to hire a licensed professional to gather this information
  • You must do your repairs within six months, and this can’t prevent you from living in your home for 15 days or more

HUD has a list of the repairs you can finance with a 203(k) loan. Have a look at this list before starting on paperwork. There are some surprising exceptions, like you can’t use a limited 203(k) for landscaping. You also cannot use a standard or limited 203(k) mortgage to convert your property into a commercial use site.

A 203(k) rehab loan is an FHA-insured loan. As a result, applicants must meet FHA requirements. The big factors in the approval process include:

Credit score. You must have a minimum credit score of 500.

Debt-to-income ratio. Generally, your debt-to-income ratio cannot be higher than 43 percent.

Down payment. You must make a down payment of 10 percent if your credit score is between 500 and 579, or 3.5 percent if it is 580 or higher.

Home value. FHA loans have limits that are set according to geographic area. You cannot get funding for a home that will cost more than the maximum loan value in the neighborhood where you want to buy.

Federal debt. You may not get approval if you owe money, such as taxes, to the government.

Foreclosure history. May not get approval if you have experienced a foreclosure within the past three years.

You must live in the home. You must live in the home you’re financing — but there’s no rule that says it has to be your last home.

Like with traditional mortgage applications, you can expect questions about your financial profile, including those about assets, employment history and liabilities.

So, how does a 203(k) loan compare to a traditional mortgage? Here’s a list of some pros and cons of a rehab loan compared to other financing options.

Pros:

Better terms. You don’t have to worry about a balloon payment. The loan is affordable, so it should provide you with a money-saving alternative — but always check the loan details before signing off so you understand your financial commitment.

Easier qualification process. FHA loans usually make it easier for people to get mortgages. You may qualify for an FHA-backed loan if other lenders have turned you down.

Helps you enter the market. You get to access money to buy and repair your home, which opens up new purchase options. This may help you find a house that’s big enough for a growing family or in your preferred neighborhood.

Cons:

Strict eligibility requirements. Your 203(k) loan might not get approval if you don’t meet FHA’s requirements. The home you want could be too expensive according to FHA guidelines, or your credit score may be too low.

Lengthy application. The need to create a work outline and stringently plan repairs can make the application process daunting for many people.

Hard to find a lender. Few people know about 203(k) loans. For this reason, it might be hard to find an FHA-approved lender who will consider one.

Getting a mortgage is an important step for homebuyers. A rehab loan may be the solution if the property they want it out of their financial reach. Perform some research on properties for sale and consider whether a 203(k) loan might be right for you.

About the Author

Cathy Lovering

Catherine Lovering has written about personal finance and health for over 10 years, with bylines on IvyExec.com and Healthline.com. She holds an LL.B. (J.D.) from the University of Victoria.

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