Renovation Financing

Many times in real estate, especially with first time home buyers and FHA qualified buyers, renovation loans are used out of necessity as opposed to convenience.  More oftern then not, buyers like this are looking at homes at lower price points in order to minimize cash out of pocket and monthly expenses.  Sounds logical, right?  There is a catch.

Those low price points normally coincide with homes that are in poor condition with many being Foreclosures and short sales that are sold "As-Is."  This means that the bank or the owner of the property will not do any work to remedy any issues and will not let any potential buyers do any work until after closing.  The problem is that any reasonable lender won't lend money on a home that needs major repairs until those repairs are done. 

Buyers ask me all of the time "So you are telling me that my lender won't close on the house until the issues are fixed and the bank who owns it won't let me do any work until I close on the house?"  Bingo!  This is the catch 22 that plagues my FTHB's.  There is however, a way around this and that's what this article is about.

FHA 203K Loans

A 203k loan is one of the most common vehichles used for first time home buyers and FHA qualified buyers to circumvent the catch 22 described above.  It is an FHA backed renovation loan that allows you to roll renovation costs into your mortgage and  close on a property that needs repair, prior to the work being done.  You and your bank decide on a renovation cost which will be rolled into your loan and held in an escrow account at closing to be dispursed to your contractor as the work is completed.  They normally dispurse 40% upfront and 60% when the work is completed, permits are closed and the the township certifies that the property is able to be occupied. (Referred to as a CO)

For Example: A home can be purchased for $150,000.  It needs $30,000 worth of work.  You would obtain a loan for the amount of $180,000.  $30,000 would be put in an escrow account at closing.  $12,000 will be given to your contractor at the start of the renovation process and $18,000 will be dispursed to your contractor upon completion.  Your amortization is based off of the final loan amount of $180,000 which is the purchase price and total renovation cost.

Things to know about the 203k loan program

• Streamlined 203K loans need to be under $35,000 worht of work.  Otherwise, you will be required to use a standard 203k which is much more heavily regualted and can take much longer.                                                                                      
• You have to have a licensed contractor submit an estimate which is then approved by or modified by an appraiser/inspector appointed to the project.                                                                                                                      
• You only receive 40% up front, you or the contractor has to front the other 60% until the work is completed.                            
• You cannot have ownership of the company who is doing the work.  You also cannot be related to any of the contractors doing the work.                                                                                                                                                           
• If the cost of the project exceeds the estimated price, the buyer will be on the hook for the difference.  If the project is completed under budget, the remaining money that was not allocated to paying down the principal of the loan.  The remaiing money cannot be redeemed as cash by the buyer.                                                                                           
• 203k loans do not require final CO inspections to be done at closing.  Buyers are able to obtain a CO specifically for the tranfer of title in order to close on the property and then be required to obtain a full CO after the work is complete prior to occupying the property                                                                                                                                                   
• Buyers cannot occupy the property during the renovation or prior to obtaining approval fromt he township.                          
• Your down payment (3.5%) is determined by the purchase price + the renovation price.  If you buy a home for $200,000 and add $30,000 worth of renovations, your downpayment will be 3.5% of the $230,000, not just the purchase price.                
• The property is inspected before closing and after completion of the work to ensure that the work provided in the estimate was done.                                                                                                                                                                         
• This can only be used on a primary residence.                                                                                                                  
• The lender will add a 10%-20% reserve to the loan amount based on the estimate which if it goes unneeded, will be applied back to the principal of the loan.                                                                                                                            
• Money can only be dispursed to the licensed contractor.  The buyer/homeowner cannot receive any money directly
•  Since a 203k loan is a contruction loan, you will normally see higher fees and interest rates.  you can always re-finance after the loan is complete but remeber, the are closing costs associated with re-financing as well.                                                                                                                                                                                

How do I know if a home will require renovation financing?

The answer to this question varies greatly on the type of loan you are trying to obtain, as well as the local market that you are in.  Conventional loans tend to have less restrictions on the condition of the property and FHA loans tend to be very strict.  In general, there are two inspections that determine whether or not the property can close with out a renovation loan:  The Appraisal and the Certificate of Occupancy.

The Appraisal - is required by the lender and paid for by the buyer in order to confirm that the value of the property is justified by the purchase price.  The appraiser will also not the condition of the property and any issues that could have an adverse effect on the value such as broken windows, holes int he roof, the presence of mold etc.  If any major issues are found, they will report back to the bank.

The Certificate of Occupancy - This is a document that is required by most lenders to ensure that a house is habitable.  It normally requires an inspection to be done by a township official to make sure there are no open permits, that no unpermitted work was done, and to ensure the home meets local fire and saftey code.  

Normally, if any of these issues regarding either inspection came up in a conventional sale when the property is individually owned, the work could be done prior to closing either by the buyer or the seller and no renovation loans would be needed.  But in the case of foreclosures and short sales, if the appriaser deems the property condition unsatisfactory, or if you are unable to obtain a CO as the property stands, you will need a renovation loan. 

You will need a renovation loan if:

• The home does not have a working heating system - Sometimes, even if a furnace or a boiler is in working condition, there might be pipe breaks or plumbing issues that prevent a bank from being able to activated or tested.                                
• Active leaks - If there are any visible or active leaks.  Normally, the condition of the roof is included in the appraisal and CO                                                                                                                                                                             
• Missing smoke detectors/fire extinguishers etc.  Check your local townships regulations to see other potential issues                  
• Missing or damaged siding                                                                                                                                           
• Broken windows / doors                                                                                                                                                     
• Structual issues                                                                                                                                                           
• Broken pipes / plumbing issues

Click HERE for more details on township regulations and examples of all CO requirements

Are There Any Exceptions?

Yes.  The stipulations vary, but generally if the repairs needed are less than a certin percentage of the purchase price, your lender will let you close without a CO as long as you put that additional money in escrow and do the work within a certain time period. 

For example: If you are buying a $150,000 home and the repairs to obtain a CO cost less than $5,000, the bank will let you put an extra $5,000 into an escrow account, close without a full CO, do the work, obtain the CO and then the bank will release that $5,000 back to you after the CO is completed. Remeber - You need to come up with the extra money to be put in escrow out of your own pocket and in addition to your downpayment and closing costs.

Common misconceptions.  Just because you are approved for an FHA mortgage and you have given the mortgage company the address of the home that you are looking to make an offer on, it does not mean that the mortgage company has approved the condition of the home.  You need to rely on your realtor's expertise and have them indicate to the mortgage company whether or not the property would require renovation financing.

If you are not using an experienced realtor, it is very common to enter into a contract, go through the process, spend money on the home inspection, appraisal, CO and realize that you cannot get a standard FHA loan or Conventional loan.   This might not be acceptable to you as a buyer and now you are back at square one.  Call me today to make sure you avoid the common costly mistakes that all people in the real estate industry tend to make.