Community Developments Investments (February 2018)
FHA Section 203(k) Rehabilitation Mortgage Insurance Program
Michael Carrier, Community Development Expert, OCC
The Federal Housing Administration (FHA) has a special loan guarantee program that offers a solution to the challenge of obtaining financing to rehabilitate distressed properties and assist in the revitalization of neighborhoods affected by the economic downturn. Established in 1978, the FHA 203(k) Rehabilitation Mortgage Insurance Program offers a loan product that combines a property acquisition and rehabilitation loan into one instrument, which is backed by the full faith and credit of the U.S. government.
Borrowers interested in purchasing homes in a distressed neighborhood may find it difficult to obtain financing because the cost to purchase and renovate the home to make it habitable often exceeds the supervisory loan-to-value limits set by bank regulators.1 The FHA 203(k) loan program addresses this valuation challenge by enabling borrowers to borrow up to 110 percent of the as-improved value, which is the value of the home after the rehabilitation work is finished. The FHA 203(k) loan program is also a good financing option for first-time home buyers or other types of borrowers unable to make substantial down payments, because the program permits down payments of as little as 3.5 percent. These loans can also be used by homeowners who want to refinance their existing mortgage and borrow additional funds for home renovation purposes.2
203(k) Loan Types
The 203(k) program offers two different loan types: Standard 203(k) loans and Limited 203(k) loans. The choice of loan type depends on the borrower’s home renovation project needs. Standard 203(k) loans are designed for borrowers who need to do extensive structural work and repairs on their properties. At least $5,000 of a Standard 203(k) loan must be used toward repairs. There is no maximum amount that can be financed for repairs. The total amount borrowed for acquisition and rehabilitation purposes, however, cannot exceed the FHA’s maximum loan amount, which varies by location and is up to $636,150 in high-cost areas. For Standard 203(k) loans, the FHA requires a consultant approved by the U.S. Department of Housing and Urban Development (HUD) to write a rehabilitation work plan and cost estimate as part of the loan approval process. The consultant also makes sure that FHA building and local code requirements are met, and oversees and inspects the rehabilitation project from start to finish.
Limited 203(k) loans are intended for borrowers with relatively small renovation projects to repair, improve, or upgrade homes that do not require structural changes. The maximum amount that can be financed for repairs is $35,000, and there is no minimum. The FHA does not require Limited 203(k) borrowers to use a HUD-approved consultant.
Table 1 lists some examples of renovation projects that can be undertaken with Standard 203(k) and Limited 203(k) funds. The FHA does not permit financing the installation of recreational or luxury items, such as exterior hot tubs, outdoor barbecue pits, or swimming pools, under either the Standard 203(k) or Limited 203(k) loan. An example of project costs can be seen in the sidebar to this article, “Sample Financing Costs Under the Standard 203(k) Program.”
Table 1: Examples of Improvements Eligible for Standard 203(k) and Limited
Source: HUD Handbook 4000.1
A borrower can borrow up to 110 percent of the as-improved value of the property, and the loan can include the purchase price of the property, closing costs, and repair costs. Inspection fees and fees to obtain building and other permits may also be included in the loan amount. If the property cannot be occupied during the rehabilitation phase of a Standard 203(k) loan, the borrower may also include six months of mortgage payments in the loan amount to pay the loan while the borrower lives elsewhere. The total amount borrowed for acquisition and rehabilitation purposes cannot exceed the FHA loan limit for the area in which the property is located. FHA loan limits vary by geography and are adjusted annually. As of January 1, 2017, the nationwide loan limit for a single-family unit was $275,665. FHA loan limits, however, are adjusted up to $636,150 in high-cost areas. The FHA maintains a loan limits section on its website to identify the loan limit for a particular geographic region such as a state, county, or metropolitan statistical area.
Any one- to four-unit dwelling is eligible for 203(k) financing as long as it is at least one year old. The borrower must intend to live in the home; investor properties are ineligible for 203(k) loans. Demolished homes are eligible if their existing foundations remain intact. Under certain circumstances, a 203(k) loan can be used to finance the purchase and rehabilitation of a condominium unit. For example, the financing can be used only for the interior improvement of the condominium unit. Additionally, the maximum amount financed for a condominium cannot exceed 100 percent of the as-improved value of the unit. Other restrictions apply for condominiums and are listed in the FHA’s Single Family Housing Policy Handbook.3
How the Program Works
To obtain a 203(k) loan, the borrower must apply for the loan with an FHA-approved lender. The FHA maintains an online Lender List which enables borrowers to search for FHA-approved lenders in their area. If the rehabilitation costs are likely to exceed $35,000, the borrower must apply for a Standard 203(k) loan and submit a write-up that includes a detailed construction plan with architectural exhibits, along with an accurate cost assessment. The write-up must be prepared by a HUD-approved consultant, who may charge a preparation fee based on the cost of repairs. See table 2 for the fee schedule for preparing a 203(k) write-up.
Table 2: Fee Schedule for Preparing a 203(k) Loan Write-Up4
Source: HUD Handbook 4000.1
If the rehabilitation costs are likely to be $35,000 or less, the borrower can apply for a Limited 203(k) loan without using a HUD-approved consultant to prepare the work write-up and cost estimate.
At closing, the borrower and lender are required to complete a rehabilitation loan agreement and establish a rehabilitation escrow account. The rehabilitation loan agreement identifies the conditions under which the lender will release rehabilitation funds. The FHA may require a lender to establish a construction contingency reserve of up to 20 percent of the cost of repairs to cover unforeseen project costs and mitigate the risk of cost overruns.5 A contingency reserve is required when there is evidence of termite damage in a structure less than 30 years old, and when utilities are inoperable in a structure that is 30 years old or more.
As construction progresses, the lender disburses funds from the rehabilitation escrow account after completed work is reviewed by a HUD-approved inspector. A 10 percent holdback is placed on construction phases until all outstanding contracts are complete. The FHA allows for five draws from the rehabilitation escrow account during the construction phase. When a draw is needed from the escrow account to pay a contractor, an FHA-approved inspector must review the work before release of the funds. The FHA requires borrowers to complete rehabilitation within six months.
The 203(k) loan program provides mortgage insurance against loan default, which reduces the risk banks face in originating and holding 203(k) loans. When a loan defaults, the FHA pays the lender the remaining principal balance of the loan and certain other expenses. The FHA requires borrowers to pay an up-front mortgage insurance fee of 1.75 percent of the total loan amount. This fee can be financed into the total loan amount. Borrowers must also pay an annual mortgage insurance fee with the amount depending on the loan term, loan-to-value ratio, and loan amount. See table 3 for the annual mortgage insurance premium schedule.
Table 3: Annual Mortgage Insurance Premium
Source: HUD Handbook 4000.1
Banks need to have sufficient management and underwriting capacity to offer 203(k) loans. Banks should consider their capacity to monitor real estate construction activities and administrative oversight to manage rehabilitation escrow accounts. Some banks do this internally through a separate construction draw unit; others outsource this function to other lenders. Lenders also must conduct proper borrower screening to ensure the borrower is not a for-profit investor.
A successfully executed 203(k) loan program can be an integral tool for improving residential properties, preserving homeownership, and revitalizing neighborhoods. Additionally, 203(k) loans help banks reduce the inventory of foreclosed and deteriorating homes. Banks also may receive Community Reinvestment Act consideration for making and buying 203(k) loans eligible for such consideration.
For more information, please see the OCC’s Community Developments Insights report “FHA 203(k) Mortgage Insurance Program: Helping Banks and Borrowers Revitalize Homes and Neighborhoods.”
4 A HUD-approved consultant is authorized to charge fees for other activities, such as preparing a feasibility study or a draw inspection. HUD Handbook 4000.1 provides a description of the activities and permissible fees.