As I speak with clients and those referred to me who have questions about doing a home renovation project the subject of cost and finance is always present.
My focus is providing guidance on how a home renovation can be paid for. What I mean by home renovation is either your current home or one you may be planning to purchase. Additionally a home can also be a 2 to 4 unit small apartment building, an attached townhouse, a condominium, a vacation house, a small mixed use building or even a log home.
I was speaking to a potential client recently who is buying a small single family home in cash, no mortgage. The client was curious about how to then finance the renovation of the house. One question for me was why not immediately do a cash out refinance mortgage. I explained that was an option since the house had no mortgage on it at all yet. A Conventional mortgage can be done as a cash out refinance on a single family home to 80% of its CURRENT value. I emphasize current because that is a key differentiator involved in paying for a home renovation. This type of mortgage would be based on the current value of the house in whatever condition it is in currently. In this case that was an old house with a barely functional kitchen, old bathroom and a furnace badly inefficient and outdated. This cash out mortgage will work as long as the house is fully functional, safe and healthy to use. But what it if was not ? What if it was damaged ? What if the plumbing pipes were missing ? Even more to the point what if the cash out mortgage just would not provide enough cash to fund the rehab ?
This client can pay in cash for the renovation but felt that would drain all available resources, leaving nothing for an emergency. Our discussion then turned to another way to finance a home rehab that didn’t involve the client’s cash. This is what I specialize in, showing clients how to secure funds to finance a home rehab either during the purchase itself or after its purchase in the future.
If you have read my Blog posts before you know I specialize in the HomeStyle rehab mortgage and the FHA 203K rehab mortgage. (I have answered questions about these before at https://perryfarella.com/2016/01/top-10-homestyle-rehab-loan-question-answers/ and https://perryfarella.com/2014/09/top-20-questions-buyers-owners-ask-fha-203k-renovation-loans/ ).
Perhaps the single most important aspect to these loans is that the current value of the property is not used to approve the mortgage. Rather the “As Finished” (After Improved Value) is used. That is the best and most amazing aspect of HomeStyle and FHA 203K. I can’t emphasize that enough. The “As Finished” value of the property is given to clients up front, before any rehab work even starts ! That is how the mortgage is approved. That is a huge advantage over doing a cash out refinance mortgage because that type of mortgage is limited to the current value of the property, not taking into account all the planned rehab work. Plus what if the property is damaged and can’t even be approved for a cash out refinance mortgage ? How do buyers purchase and finance a rehab of a damaged home ? Or one that has no equity to borrow out ? The answer is to use either FHA 203K or HomeStyle. The reason why is both allow the use of the “As Finished” value to approve the mortgage rather than the property’s current value. What is meant by “As Finished” value is what the home will be worth once planned improvements are installed. These can be new mechanical systems, a new kitchen, functional plumbing, a room addition and so forth. All defined on paper in a General Contractors proposal with labor and material costs specified. We then allow the Appraiser to take all that into account to arrive at the future “As Finished” value. Or put another way the new equity that is known to be created by doing all the rehab work.
Here is an example of how this can work:
- Buyer finds a home that is older, outdated selling for $100,000. The furnace is missing but the house is otherwise intact. Even if the buyer paid $100,000 in cash to purchase the home it is still not eligible for a cash out refinance since it cannot be safely occupied with no furnace in most states. Plus the home is assumed to be worth no more than the $100,000 the buyer is paying. This buyer plans to buy with just 5% down. Meaning there is no likely way to take cash out with a second mortgage or home equity line of credit loan since there is not enough equity to borrow out to fund the rehab work.
- Buyer plans to replace the furnace and remodel the kitchen and the two baths. That will cost $50,000.
- Using either the FHA 203K or HomeStyle rehab loan the current value of the property is not used to approve a mortgage. The fact the buyer is paying $100,000 for it is important but more important is the added $50,000 for rehab and what that will do for the “As Finished” value of the property.
- In this example let’s assume the “As Finished” value is assessed to be $180,000 with the $50,000 rehab work taken into account by the Appraiser. Meaning that the total transaction is $100,000 + $50,000 rehab dollars = $150,000 for the transaction. But the final “As Finished” value is 20% higher or $180,000.
This is the single greatest reason to finance a home rehab project – “As Finished” value. We know in advance the value of the completed home will be $180,000 and the Buyer has created or discovered what we call “hidden equity”. This new equity is factored in up front so the loan can be approved with the certain knowledge and requirement that all the proposed rehab work be completed exactly as described on paper by the General Contractor to arrive at this future value.
These days it is generally about $5.00 a month on a 30 year term loan to borrow each thousand dollars of mortgage money. As above to borrow the $50,000 rehab dollars it will be $250.00 a month. Plus that $50,000 of rehab dollars adds an additional $30,000 of equity in this example. For owners or Buyers who do not have the cash to pay for the rehab this is an excellent way to do it.
I always tell Buyer clients to “Buy the Worst House in the Best Location”. That’s usually the best way to go about purchasing a home to renovate.
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!