Is a HUD 203(k) loan right for you?

Richard Barrington | Improvement Center Columnist | January 5, 2015

Buying a fixer-upper can be a great way to get a bargain on a house. The more work the property needs, the better the deal you might get -- but then the problem becomes one of financing those renovations. Fortunately, a government program known as a HUD 203(k) loan can provide the solution.

What is a HUD 203(k) loan?

Two characteristics define a HUD 203(k) loan:

  1. It is a mortgage insured by the Federal Housing Administration (FHA), which is a branch of the U.S. Department of Housing and Urban Development (HUD). The FHA does not make loans, so you need to apply through an FHA-approved lender. However, having FHA insurance backstop these loans is what helps make them available.
  2. A 203(k) loan is a very special kind of mortgage. It lends money based on a combination of the initial purchase amount and the estimated value of the property once the repairs are completed. Thus, any part of the loan not needed for the initial purchase goes into its own escrow account, where it is available to pay for planned renovations as the work is done.

The alternative is to obtain a non-FHA mortgage for the purchase, and then either put up cash or obtain a conventional renovation loan to pay for the necessary work on the property.

house that needs fixing up
This house could qualify for a 203k rehab loan

HUD 203(k) loan vs. conventional loan: advantages and disadvantages

Here are some of the advantages of a HUD 203(k) loan:

  • The government has your back. The backing of FHA insurance can make loans available in situations where an uninsured loan would not be approved.
  • Low money down. The down payment for these loans can be as low as 3.5 percent of the value of the loan; in the aftermath of the housing crisis, it is rare to find conventional mortgages or renovation loans with such a low down payment requirement.
  • You save by going long. A HUD 203(k) loan finances improvements with a 30-year loan at long-term mortgage rates, rather than requiring a high-interest loan that must be repaid over a shorter period, or a heavy investment of cash.
  • Try the combo. In many states, there are programs to combine HUD 203(k) loans with other programs.

Those are important advantages, but at the same time, a HUD 203(k) loan can have some disadvantages compared to conventional loans:

  • You'll have to live with the results. These loans are available to owner-occupants only, so property investors need not apply.
  • It's personal, not business. HUD 203(k) loans are targeted for residential, not commercial properties. Some mixed-use properties may be eligible, if the use is primarily residential and the 203(k) funding is used solely for the residential portion.
  • Safety first! Health, safety, and energy conservation standards must be met before any of the loan can be used for other improvements.
  • Forget the swimming pool. Improvements that are considered luxury items may not be made with a 203(k) loan.
  • Choosing the right contractor is a key to success. Close coordination with contractors is required, from estimating costs up front, to performing the work according to HUD standards. Home owners using a 203(k) loan would be wise to focus on contractors with an extensive amount of experience doing work with 203(k) loans.
  • Get ready for writer's cramp. The application process can be tricky. Both the property and the applicant must be shown to meet eligibility standards, and dual appraisals may be required -- one for the initial purchase of the property, and the second for the projected value of the property after renovations are done.
  • The sky isn't the limit. The amount of the loan will be subject to FHA loan limits.
  • Availability is limited. Not all lenders make HUD 203(k) loans.

Don't be misled by the relative sizes of the above lists. The disadvantages only outnumber the advantages because there are so many detailed specifications governing these programs. However, because the advantages can make all the difference in whether financing is available and affordable, they can easily outweigh the potential disadvantages.

The HUD 203(k) loan is literally a forward-thinking program -- it lets you obtain financing based on what a property will be worth once you are done fixing it up. It may not be worth jumping through all the application and administrative hoops for smaller loans, but for big projects, a 203(k) loan may be the only source of cost-effective financing.

About the Author

Richard Barrington has earned the CFA designation and is a 20-year veteran of the financial industry, including having previously served for over a dozen years as a member of the Executive Committee of Manning & Napier Advisors, Inc. Richard has written extensively on investment and personal finance topics.