What's a 203(k) loan and how can it help Long Island first-time homebuyers?

House hunter Mason Sofia fell in love "with the opportunity of a wreck," as his real estate agent put it.

Sofia, 28, an architect, and fiancee Brooke Campione, 28, a nurse, were tired of move-in ready homes being whisked away and decided to buy a 1960s ranch that had good bones but needed a new roof, siding, windows, wall repairs and other work.

"It's the perfect opportunity to create something we want," said Sofia, who closed on his five-bedroom, 2,200-square-foot East Northport house in June. "It was exactly what I and she had been looking for to start, a big garage and plenty of room to start a family and a huge backyard. And the neighborhood is fantastic."

The key to the couple's switch in house hunting strategy: A 203(k) loan, which covers the estimated cost of renovations on top of the home purchase. They borrowed just under $800,000, including about $150,000 for renovations.

''The 203(k) allowed us to get a foot in the door," Sofia said.

What is a 203(k) loan?

The 203(k) loan is probably the best known type of rehab or construction loan on the market. People can use it to buy homes that need repairs or updates, rolling the purchase price and renovation cost into one loan. Homeowners can use it to refinance their existing mortgage to upgrade their home, make the house presentable for a sale or fix damages.

These are long-term loans insured by the Federal Housing Administration, part of the U.S. Department of Housing and Urban Development, and offered by FHA-approved lenders. The maximum loan amount cannot exceed FHA’s limit for the area, currently $1,089,300 for a single-family home on Long Island.

The 203(k) program covers a range of renovations and requires a federally approved expert, such as an appraiser or construction professional, to oversee the work and pay the contractors. The project can be as complex as razing and rebuilding a house — as long as the existing foundation is kept — or as simple as making over a bathroom.

The funds can be used to buy an uninhabitable house, which conventional mortgages do not cover. The program is not for investors, only borrowers who plan to make the house their home.

The FHA sets the rules as part of Section 203(k) of the National Housing Act. The program started in 1978 in an effort to protect people from home improvement loans that carry high interest rates and short repayment periods. It’s aimed at helping first-time and low-income buyers and also restoring distressed house to boost the supply of quality, affordable homes.  

How does a 203(k) loan help first-time homebuyers?

Some listing agents, lenders and mortgage brokers see 203(k) as a needed antidote to Long Island's challenging market for buyers.

Especially in a seller's market, they said, the sales price often drains the buyer's funds, leaving little for renovations. Also, move-in-ready homes are snatched almost as soon as they're listed, real estate veterans said, because many first-time homebuyers, especially millennials, don't want to undertake repairs.

"They don't want to close and not move in for another three months," said Peter Browning, treasurer of the Empire State Mortgage Bankers Association, a trade group, and vice president of business operations for East Coast Capital Corp., a Melville-based lender. "They want to have a house that's already fixed up for them, move in, turnkey. They want to buy a house like they're buying a new car."

That leaves many homes needing work languishing on the market. 

At the same time, many agents, sellers and some mortgage professionals don't know much about the 203(k) program, experts said.

"203(k) is the most important product out there and the most underutilized product out there," said Pete Muratore, president of Silver Lining Funding, a Ronkonkoma-based mortgage broker.

Sofia said he is grateful for the program, especially its minimum 3.5% down payment, which allowed him and his fiancee to buy a home as they pay off student loans and save for their wedding. The couple has been ripping out some walls and pruning parts of the large yard, where they may hold their wedding to save further on costs.

"It opened the largest door for us and gave us the most room to renovate," Sofia said. "We both had good credit, but the conventional loans were that much stricter."

Who can get a 203(k) loan?

There are two types of 203(k) loans.

The limited 203(k) loan covers up to $35,000 and can be used to make minor repairs, such as making a house ready for sale with new paint, carpet and other improvements, but not structural repairs.

The standard 203(k) loan covers renovations that cost at least $5,000, structural repairs, labor, equipment, appliances and other work that improves the value of the property. The loan amount cannot exceed the projected value of the property after renovations.

Borrowers can have a credit score as low as 500, compared to 620 required by  mortgage insurance giants Fannie Mae and Freddie Mac. Those with scores of 580 and above can pay as little as 3.5% down, while borrowers with lower scores would have to pay at least 10% down. The maximum debt-to-income ratio is 43% in most cases, while Fannie Mae and Freddie Mac have a maximum ratio of 36% for most mortgages.

The 203(k) program may not work for all buyers, and a lot of agents, brokers and lenders avoid it due to requirements and potential delays to the closing, agents and mortgage experts said.

"There are a lot of moving parts," said Robert Cicero, who has inspected homes for 203(k) loans as president of Premier Home Inspection Group in Lake Grove.

Consultants help keep things on track

She probably protected me from getting the wrong contractor, from getting a contractor who was going to dash off with a $20,000 deposit.

— Patrick Nolan, of Babylon

Once 203(k) applicants pick a property, they face two key missions: submitting renovation plans and working with a HUD-approved consultant.

Patrick Nolan was grateful to his consultant when he was buying his first home with a 203(k) loan 11 years ago. The consultant told the contractor that if he didn't have funds to buy supplies, he should back out of the project, Nolan said.

"She probably protected me from getting the wrong contractor, from getting a contractor who was going to dash off with a $20,000 deposit," said Nolan, 41, of Babylon.

The program requires all work to be completed within six months, and the renovation plan must provide details, including contractor estimates and any engineering and architect reports.

For many, a top advantage of the program is the HUD consultant. The consultant plays a key role before and after the loan closes, acting as a liaison among the buyers, lender and contractors. Sometimes, the lender will pick the consultant, but homebuyers can also interview and pick one from HUD's list. Limited 203(k) loans don't require a HUD consultant.

203(k) loans may come with delays

One of the biggest raps against the program is the potential delay in closing.

"On a purchase, you would think maybe 45 days for a normal loan [closing]," Muratore said. "On a 203(k), you've got to add probably another 15 days on to that. But that's if everybody's working together. I've had some contractors that take three weeks just to get their insurance documents over."

Instead of one appraisal, two are required before the loan closes — one on the current state of the house plus an estimate of post-renovation value based on a review of the proposed work, lenders and brokers said.

It can take time for a homebuyer to interview and pick contractors, settle on a work plan and possibly obtain work permits, they said.

Experts said borrowers can avoid headaches by working with those experienced in 203(k) loans.

"It's not like it's a hard thing to do," said Richard Drury, Sofia's agent, an associate broker at Douglas Elliman. "They have to have the right people in place to give them guidance."

Costs in 203(k) loans

It's a give and take when it comes to finances in a 203(k) loan.

The interest rate can be up to three quarters of a point higher than standard FHA loans, which are geared toward first-time or lower-income borrowers. But the 203(k) rate is generally lower than market rates on conventional mortgages, mortgage industry experts said.

Sofia said he got a 6.75% rate while lenders were charging about 7% for conventional mortgages when his loan closed in June.

Extra professional fees can be several hundred to more than a thousand dollars, covering appraisals, the consultant and paperwork reviews by the lender, brokers and lenders said.

Another added cost is the contingency reserve. Most lenders require 10% to 20% of the renovations budget. The FHA calls for a maximum of 20% only in certain cases. For example, the FHA requires 10-20% contingency when utilities are not working in homes that are at least 30 years old. Once renovations finish, monthly loan payments are lowered when remaining contingency funds are no longer needed, experts said.

The 203(k) program charges a mortgage insurance premium of 1.75% of the borrowed amount. A 1.75% fee on a $500,000 mortgage would be $8,750. 

That's on top of a monthly insurance payment that lasts the life of the loan.

"You have to refinance to get rid of it," Sofia said. He and mortgage experts said refinancing into a conventional mortgage can possibly save on the 203(k) insurance costs.

Many fees and the contingency reserve can be rolled into the loan.

In what may be a financial advantage to some borrowers, the FHA program recognizes that some of the homes start out uninhabitable due to a hole in the roof, for example, or no electricity, no plumbing, no kitchen or other unsafe conditions.

Borrowers don't have to pay the monthly mortgage if they cannot live in the house during renovations and these payments can be added to the loan amount. It avoids having the homeowners pay for rent and the mortgage while the house is under repair.

"It allows you to roll in the mortgage payments but only for the duration of time that I say the house is uninhabitable," said Cicero, the home inspector. "If the home is going to take three months to complete and it's going to be uninhabitable for two months, they would allow you to roll in the mortgage payments for two months."