Our experience using an FHA 203k loan to purchase and repair our first multi-family house.

4/10/2021

Summary

When we purchased our first multifamily home in Providence, RI in 2017, we decided to take advantage of a loan product called the FHA 203k loan. This type of loan helped us complete a couple of the major renovations needed on the house. Over the couple months of the mortgage application process and then for a time after closing, we learned the pros and cons of the FHA 203k. This article will give an overview of the FHA 203k loan program, pros and cons, tips and discuss whether or not I would recommend this type of loan to buyers.

by Christian Scully

What is an FHA 203k loan?

The FHA or Federal Housing Administration is a government agency that insures loans made through FHA-approved lenders throughout the US. FHA loans offer some great benefits. FHA loans are generally easier to qualify for, providing a great option with borrowers who are lower income, have higher debt to income (DTI) ratios and/or lower credit scores. For these borrowers, the interest rates are generally lower than conventional loan products. FHA loans also allow the borrower to make as little as a 3.5% down payment.

The FHA 203k loan is a type of FHA loan that also includes funds for renovations. The borrower closes on one mortgage, that includes enough to purchase the home and additional funds to cover any repairs or improvements needed. There are two types of 203k loan: the Limited and the Standard. The Limited 203k is the easiest way to go and can provide up to $35,000 in funds for any improvement that is non-structural. Anything beyond that and the borrower would need a Standard 203k loan. Let's look at some of the advantages of using a 203k loan.

What are the advantages to using an FHA 203k loan?

By considering an FHA 203k loan for your purchase, you could potentially widen your search parameters to include homes that need renovating. In a market with low-inventory, having more potential homes to consider can help. Without having the cash on hand to complete those renovations, the FHA 203k makes it possible. Borrowers are able to borrower more than the purchase amount. The renovation funds are then placed in an escrow account (just a holding account that the lender manages), from which all contractors will be paid for their services. Even though you are getting funds for the purchase and funds for the renovations, borrowers just have one closing that takes care of it all. That eliminates the needs to seek an additional loan for renovations after purchasing a home.

Borrowers who might find typically purchase a home and delay necessary renovations due to lack of funding are able to take care of big projects immediately. If the home is a 2-4 unit multifamily and the extra units are going to be rental units, then getting them renovated and filled with tenants as fast as possible is crucial. Dealing with contractors can be challenging, and it is definitely possible to be scammed or taken advantage of. With the FHA 203k loan process, contractors are paid 50% at the start of the project and 50% when the project has been completed and inspected by a representative for the lender. That nearly guarantees that the work will actually get done and will meet FHA standards.

Quick Pros for the FHA 203k loan:

- Access funding for necessary or desired repairs, borrow funds based on the future (after repair) value of the home.

- Only pay for one closing, as opposed to seeking a second loan to pay for renovations after moving in.

- Take care of big renovation projects immediately, as opposed to waiting until you've raised funds.

- All work is inspected before payments are issued, so there is a near guarantee that the work will get completed.

- 203k loans allow you to shop homes that need repairs, opening up more options in the market.

What are the challenges when using an FHA 203k loan?

First, if you are taking advantage of the Limited 203k, then you will soley be responsible for finding contractors to do the work. You will first need to determine exactly what the home needs, then find qualified professionals to provide a quote. This is where the first challenge will arise. Because the payment schedule is strictly set by the lender, contractors may not want to deal with 203k loan borrowers. If the contractor is not familiar with the process, you will have to explain that if hired, they will receive half the payment up front and half upon completion and the work is inspected. There are very few general contractors who will take on 203k work.

For large projects, the requirements are too time consuming or challenging for most contractors to deal with. They can find plenty of work elsewhere. One big challenge that we experienced was very surprising. The lender required us to have all final quotes split into two numbers: one price for the materials and one price for the labor. The quotes needed to be signed, with the contractors contact information. You would think that would be super easy! It was extremely frustrating how challenging it was simply getting quotes in the correct format. We even abandoned specific projects because we couldn't get a contractor to send a correctly formatted quote, and the project wasn't crucial so we just skipped it to not delay the loan process further.

Tip: Search Google for 203k contractors. Some areas will have contractors specializing in this renovation process.

If the house you are purchasing has more than $35,000 in renovations needed, then you will need to go with the Standard 203k. This will require you to enlist the assistance of a 203k Loan Consultant certified by HUD (US Department of Housing and Urban Development). This step does another step to the loan process. Because of the additional steps with the 203k process, it may negatively affect the attractiveness of your purchase offer, which may be important to consider in a hot seller's market.

Quick Cons for the FHA 203k loan:

- It may be difficult to get contractors to provide quotes in the required format, even though it is fairly simple.

- Contractors may not want to work with the FHA 203k payment schedule.

- If you need repairs over $35,000 you will need a Standard 203k, which means working with a certified 203k consultant.

- An FHA 203k loan could take longer to close than a normal FHA or conventional loan, which may affect the attractiveness of your offer. This might be important in a hot sellers market where the seller has many offers and will likely choose the best or most simple offer.

- Purchasing a house needing significant renovations may delay the borrower's ability to move in to the property after closing.

- Purchasing a 2-4 unit multifamily with significant renovations needed may delay the borrower's ability to rent out the units and receive rental income.

Tip: It is important to note that even if the borrower is unable to move into the property due to extensive repairs, mortgage payments will begin after closing. However, you may be able to add up to 6 months of mortgage payments to the loan amount, provided the home still appraises for at least the total loan amount.

Do I recommend using the FHA 203k loan?

We used the 203k funds to replace the roof, install two large skylights in the attic that would eventually become part of a new unit, remove the old brick chimney stack that was falling over and replace it with a stainless steel chimney stack witha new steel liner. We also used the loan to purchase a new stove, a new refrigerator, and 2 coin-op laundry machines for the basement.

I would definitely recommend considering applying for an FHA 203k loan if you think it might solve your particular problems. If you need or want repairs and renovations and have limited funds, then reach out to a lender that has experience with the 203k process. They need to be FHA-approved, but you also want to check that they have actually completed a 203k loan recently. Also, discuss your plans to purchase and renovate a home with the 203k loan with your realtor, so they can help you find the right properties and present your offer in the best way possible. If you do choose to pursue a 203k loan, just be prepared to hound contractors for correctly formatted estimates.

Important notes:

- The after repair value (ARV) needs to equal or exceed the purchase price + the renovation funds. The home will need to appraise for at least the ARV in order to be approved.

- The total loan amount including renovation funds cannot exceed the FHA loan limit for your geographic area. You can determine the FHA loan limit for your area here.

- The renovation work typically must begin within 30 days of closing and must be completed within 6 months. Again, this comes into play when finding contractors willing to work within the 203k guidelines. If they are too busy to start quickly on your project the contractor may pass on the opportunity.

+ Better Tip:

It will be challenging to find a general contractor to do the work if you have several different repairs that need to be done. It is difficult enough to find a contractor to do good, honest work for a regular job. For transparency, consider yourself the "general contractor" and look for "subcontractors" to do each individual job. Find a plumber, electrician, painter, etc. separately so you get honest and fair quotes for each item. If the contractor does not have a decent website, or doesn't appear to be technically savvy (basic word processing/computing skills) then don't waste your time contacting them. There is likely going to be a lot of back and forth just trying to get the estimate to look correct. Always try to get at least three estimates from three different contractors for the same project, so you can compare and contrast.

Searching for contractors definitely is a topic for a whole other article. But for quick tips, ask your realtor for any trusted referrals. You can also reach out to other experienced real estate investors in your area who likely use contractors regularly.