As I meet with clients who will be purchasing a home to rehab they often ask me what are different ways pay to for it. Certainly the obvious answer is to use cash. But in asking the question it may mean cash is not an option. Another question I’m asked is can they secure a Home Equity Line or Loan on the new house to fund a rehab. The answer to this depends on whether there is any equity in the home to borrow out. If purchasing with a smaller down payment then the answer may generally be no.
I then explain how an FHA 203K purchase & rehab loan can work in this situation. The 203K has many advantages. Put simply it is a first lien mortgage insured by FHA that allows a home buyer or current home owner to add rehab funds into a 30 year mortgage. Below I want to hit the highlights and then give a brief example of how 203K can work.
- Down payment as little as 3.50% of both the purchase price and rehab dollars added together on a single family house, FHA approved condominium, town house, mixed use building or 2 to 4 unit property, always owner occupied.
- Down payment can all be a gift from relatives or someone in a close familial type relationship that can be documented as such.
- When purchasing the Seller can pay up to 6% of sale price for Buyer’s closing costs and pre-paid items like the first year’s homeowners insurance policy premium, etc.
- Rehab dollars are added into the same 30 year loan at the same fixed interest rate, repaid over 30 years. The interest rate can never change over the 30 years.
- Amount of rehab dollars is based not on what the Buyer pays for the home but rather on what the home will be worth with all the renovation completed. This is great news – the Buyer gets credit now for the planned rehab value when an Appraisal is done using the documents detailing the renovations or improvements to be made after the Buyer purchases the home. *** This feature is perhaps the single best aspect of 203K ***
- 203K allows the home to be mortgaged to 110% of its value. This means that FHA has an interest in 203K being used to bring back decrepit or unused properties so housing stock is renewed. The Buyer can fund a rehab more thoroughly this way.
- 203K builds in a 10% to 20% emergency reserve fund into each mortgage. This reserve fund is based on the rehab budget itself. The emergency funds are held back so that during construction should an unforeseen repair be required there are extra funds to cover it. If never used the mortgage is reduced by the same amount at conclusion of rehab. In this way the home owner is protected from surprise costs seen in many rehab projects.
- A Buyer can add in up to 6 months of house payment money into the rehab dollar portion of the mortgage. The idea here is that if the property cannot be used for up to 6 months during rehab, funds are there to pay the mortgage automatically. This saves Buyers from paying to live in their current residence – paying the rent for example, and making a mortgage payment on a property that cannot be safely lived in at the same time.
- FHA 203K requires that a Buyer occupy a property for 12 months. But after that period the property can then be fully leased to tenants. Here is an opportunity for a Buyer to use a 203k to rehab a property, occupy it and then convert it to a rental investment.
- FHA will allow a Buyer to have a co-signer if need be, called a non-occupant co-borrower. This is done to help a Buyer afford the property and the rehab cost that is planned.
- The FHA 203K lender assigns a 203K Construction Consultant to assist the borrower in determining what must be repaired and approving a reputable General Contractor to execute the work, inspect it and authorize rehab funds be paid out to the Contractor as rehab progresses. In this way even an inexperienced Buyer can manage a rehab project.
Here is an example of how this 203K purchase may work:
- Buyer finds a home for $200,000 but it needs updates and repairs to make it usable
- Repairs will cost $40,000
- A 20% Reserve is done which is 20% of $40,000 or $8000. This $8000 is not assigned to any particular repair item, rather it’s held back as an emergency fund in case its needed during the rehab to pay for vital surprise repairs discovered later
- Down payment is 3.5% of the $248,000 or $8680 and loan size is $239,320
- Seller is paying 3% of the $200,000 purchase price for buyers closing costs or $6000
- Appraiser views the house while reading the General Contractor’s written description of all repairs as approved by the 203K Consultant to be sure the home will be worth about $248,000 when rehab is done. Since FHA will allow the house to be mortgaged to 110% of value, the appraised value can be as low as $217,564 for loan approval.
Another way to view funding a rehab with a 203K mortgage is to look at what it might cost in payment each month for the rehab dollars. Interest rates can vary any time but an example might be $5 in payment each month on each one thousand dollars borrowed. In this example with $48,000 total borrowed for rehab that would be 48 times $5 or $240 a month added to payment for the complete rehab.
I always ask clients my own question, “Where can you borrow the funds for rehab at this cost and have the new value of the house now and enjoy it every day ?”
I hope this post has been helpful and encouraging to those that may have thought a Renovation project was too complex or beyond their ability to manage. My intent is always to inform, educate, and generate discussion. Please call me or email me directly or visit my website for more information on renovation loans. I welcome your comments and questions!