"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 Ren