"First Time Fixer Upper" is a seven part series on buying and financing your first rehab project, with new posts published weekly in January and February 2020. This is the fifth post in the series.
If you’re in the market for a fixer upper, by now you’ve probably seen a range of homes available that might require anything from a kitchen and bathroom update to a full gut rehab, some of which might need considerable investment in repairs and renovations. Unless you’re sitting on piles of cash, you probably don’t have the funds available to purchase and renovate your new fixer upper on your own. Fortunately, there are multiple lending options available to you to fund a purchase and renovation without requiring all of your cash up front.
If you’re getting ready to start your property buying and renovation journey, the first step is to get pre-approved for your maximum mortgage amount by a qualified lender. This will tell you your maximum loan amount including purchase and repair funds, so it will set your max project budget right off the bat. You can even set your budget lower than your max, and I generally recommend that you do, but this will tell you the top of your range. This post is all about the different loan options you can choose from to get you started.
You can use a residential “renovation loan” or “rehab loan” to allow you to roll the funds for acquisition and repairs into one fifteen or thirty year mortgage at a rate that’s usually only marginally higher than that of a conventional home mortgage. Although you will pay a slightly higher interest rate than you would on a non-renovation loan, you’ll have the funds available immediately and you’ll only have to pay closing costs once.
Why use a renovation loan?
Financing your renovation costs into your regular long term home mortgage is beneficial because it allows you to purchase a home or building in really bad shape and then put your funds toward renovation and upgrades, while the loan is still secured by the home itself as collateral. There are also several loan options available that you can access even with lower credit and low or no down payment, making this a great option even for first time buyers. Better yet, some programs will allow you to purchase multi-family (up to four units) and mixed-use properties, as long as the building will be greater than 50% residential when it is completed. This can allow you to purchase a property as an investment, living in one of the units and renting out the others to offset or exceed your monthly payment obligations. Talk about a win-win!
Though there are some obvious advantages to this type of loan, it’s important to be aware of the drawbacks as well. Most renovation loan programs hold onto the repair funds in escrow, and they only release payments to you or your contractor(s) in “draws,” which are issued as portions of construction are completed. Because of this, the bank retains control over the money rather than you, and in some cases this can cause some serious roadblocks and delays to the construction process. In the case of cash or hard money construction financing, you would have more control over how, when, and to whom the funds are distributed, streamlining the process and eliminating unnecessary delays. Though these loan programs can be frustrating in their administration, these roadblocks can be managed if you understand the rules.
What kind of loans are available to me?
The concept of a “renovation loan” is used widely in the banking industry, and programs are offered by the US government, nonprofits, local municipalities, and some local or national banks and credit unions. The most commonly used renovation mortgage programs are administered by the US Federal Government and widely available through just about any mortgage broker. There are also some mortgage or special financing programs run by non-profits and local municipalities, so be sure to do some research on what is offered in your area.
Here I’ll introduce a few of your major renovation loan options and the pros and cons of each, but this is certainly not an exhaustive list and I encourage you to do your own research and shop around.
FHA 203(k) Mortgage
The FHA 203(k) mortgage is one of the most widely used options, and for good reason. Because the 203(k) is backed and insured by the Federal Housing Authority, it is available to most owner-occupant borrowers looking to purchase and renovate a home. Borrowers can access this loan with as little as 3.5% down on the total mortgage funds (acquisition plus repairs), but the total loan amount is limited to the lesser of the FHA limits for the area and 110% of the ARV, or “after repair value” of the property. A special “ARV appraisal” will be used to determine the after repair value based on proposed improvements and the total amount of the loan cannot exceed 110% of the ARV. You’ll need to have your architect or contractor submit plans and a full scope and bid before the appraisal can be ordered.
Though this loan is very accessible for most borrowers, one downside is that the lender will require PMI, or private mortgage insurance, for the life of the loan, even after accrued equity during ownership exceeds 20% of the total value of the property. The only way to get rid of PMI on an FHA loan is to refinance your mortgage and pay closing costs again.
The biggest thing I like about the 203(k) mortgage is that it can be used to finance the purchase and renovation of a mixed use property, provided that the residential portion of the project exceeds 50%. The renovation funds can only be used to repair the residential units, but this loan will definitely get you in the door.
Fannie Mae HomeStyle Renovation Mortgage
The HomeStyle Renovation loan is similar to the FHA in that it also offers acquisition and renovation funds within the same mortgage, but it only applies to residential properties. The maximum LTV, or “loan to value”, ratio for this loan is 97% of the ARV, meaning that the amount of the loan is limited by the future value of the home after repairs are completed. This also means that you can get into this mortgage with only 3% down, which is 0.5% less than the FHA loan. A really great side by side comparison of these two loans can be found here. The biggest difference is that Homestyle can be used for residential properties only and cannot be used to finance the purchase of mixed use properties.
This is also a very flexible loan, and it applies to single unit owner occupied, single unit second home or investment property, multi-family up to four units (provided that the owner lives in one of them), and even manufactured homes. This loan can provide renovation financing up to 75% of the total loan amount, meaning that you can spend up to 3x as much on the renovation as the property purchase itself! Similar to the FHA, borrowers will have to submit full plans and specifications to the lender prior to the appraisal, which can be prepared by either a licensed architect or contractor. You will also need to have identified and contracted with your contractor prior to loan closing.
Freddie Mac Renovation Mortgage
Freddie Mac also offers a similar renovation mortgage option, which can be used for all the same types of properties as the Fannie Mae Homestyle. For a single-unit, owner-occupied property, the maximum LTV is 95% and requires a minimum of 5% down. Like the Homestyle loan, this loan is for residential properties only.
NACA Best in America Mortgage
Another interesting option that I have seen my clients use is the NACA (Neighborhood Assistance Corporation of America) Best in America Mortgage. This one is unique in that it is administered by a non-profit in partnership with Bank of America as the lender, and they offer no money down, no closing cost purchase and renovation mortgages at below market rates with no PMI. In addition, they will finance both single and multi-family properties, as well as mixed use properties provided that the residential portion of the building exceeds 50% and the owner occupies one of the units.
This mortgage can only be used to purchase owner-occupied homes, so second homes and investment properties are not allowed. The program is also targeted to low- and moderate income first time buyers, and the buyer household income must be below 50% AMI (“area median income”) for the area in which they live. If they exceed the income limit, they are considered a “non-priority” buyer and can only qualify to purchase a home in certain low to moderate income communities that NACA has deemed “priority areas.”
This is a mission driven program, and their stated mission is “to provide affordable homeownership to low-to-moderate-income people and communities.” For this reason, perfect credit is not required and everyone who is eligible receives the same excellent terms. You can learn more about NACA’s eligibility requirements here.
If you qualify, a NACA mortgage can be a really strong option. However, in my experience this loan may actually be too good to be true, and NACA is notorious for taking months to actually underwrite and close the loan. Many buyers have actually lost the property they had under contract because NACA has been unable to meet the closing date and the buyer then falls out of contract. At the time of this writing, I have a client who went under contract using NACA back in August, and it is now the end of February and we are still waiting on the appraisal to come back -- a full six months later.
Furthermore, though NACA does offer renovation funds for properties needing repair, the distribution process can be complicated and many contractors who have worked on a NACA administered project before have issued warnings about the process. Some contractors simply won’t work on these projects for fear of not being paid in full or on time.
These are a few of the most common renovation loan options available to you, and depending on the details of your project one may work better for you than others. Overall, if you’re doing an owner-occupied single family renovation I would recommend either the 203(k) or the Homestyle loan, and it’s always a good idea to shop around with different mortgage brokers to see what kind of rates they can offer you. Your rates will vary with both your credit score and the standard interest rate on the market at the time.
If you’re doing a mixed use property, I would recommend the 203(k) if you can afford the down payment and closing costs simply because you will be able to move through to closing much faster than with NACA and avoid the risk of losing your contract on the property. That said, NACA has an unbeatable first time home buyer program that may bring home ownership within reach for those who otherwise may not be eligible.
Don’t forget to look into local options in your area also, there may be special programs in your city for first time buyers that could offer better opportunities than the national programs outlined here. In general, first time home buyer programs are typically limited to owner-occupied residential properties and often have maximum income limits, so they’re not necessarily a fit for everyone. Some may also offer assistance grants to cover the down payment or closing costs.
Regardless of which mortgage product you use, it's definitely worth looking into a renovation loan to finance your home purchase and can afford you huge opportunity to upgrade and customize your home for the same total project cost as you might spend on a move-in ready home. With interest rates currently at all time lows, there has never been a better time to get started!
Heather Medlin is a licensed architect and principal of Ginkgo Vernacular LLC, serving residential and commercial owners in the greater Philadelphia area. She specializes in regenerative design and development for both building retrofits and new construction.