It takes a special person to see the potential in a home that’s in need of serious rehab. If you’ve got your heart set on buying a dream fixer-upper — but don’t have the savings to cover both a down payment and a renovation — there are loan products out there that could help you make your dream a reality.
Consider a loan with a built-in reserve
The Federal Housing Administration (FHA) 203(k) rehabilitation loan or Fannie Mae HomeStyle Renovation Mortgage could be good financing options for buyers seeking fixer-uppers. These loans allow you to purchase the home with a reserve that’s put in escrow to fund renovations.
One caveat: There are strict guidelines, and it’s important to understand how these loans work if you’re considering a handyman special.
“These are good for people who can afford the mortgage payment, but they don’t have a lot of cash on hand to be able to pay for these renovations outright,” says Cara Ameer, broker associate and real estate agent at Coldwell Banker Vanguard Realty based in Ponte Vedra Beach, FL. “If the scope of the renovation is big and it’s a total overhaul costing six figures, you probably should do some kind of renovation loan.”
First-time homebuyers with limited budgets who want to live in a particular area can usually benefit from buying a less expensive home that’s a fixer-upper — and these loans make it feasible. “[A 203(k) or HomeStyle conventional renovation mortgage] allows consumers to go in and purchase the home and work with the contractor — the amount to renovate can be included in that one loan,” says Bill Trees, national renovation program manager at Wells Fargo Home Mortgage.
If you’re looking to make minor changes, however, borrowing money through a renovation loan may not make the most financial sense.
How do these loans work?
Once the mortgage closes, one portion pays for the house while the other is deposited into an escrow account. As work is completed, the mortgage lender sends an inspector to review the work. If the work is completed to the scope of the project and to state and local codes, money is released to pay the contractor.
How much can I borrow?
The loan amount depends on the appraisal value and your renovation plans.
“The consumer will find a house and work with a contractor or HUD consultant, depending on the program, and determine how much it will cost to do the repairs they want to do,” says Trees. “When the appraisal is ordered, it’s ordered as if all the renovation work has been done — you have to submit the scope of work and the bid to the lender and appraiser so they know what you plan to do.”
The scope of your renovation may have to be dialed back in some cases, as neighborhood comps have to support the home’s postrenovation value. A renovation loan makes sense only if the renovation costs don’t put the house’s new value far above comparable properties. If they do, you may have to wait on making additional renovations or pay for them yourself.
What about choosing the contractor?
Take your time finding the right contractor for your project and check that they’re licensed, insured, and in good standing. Be sure to call their references and ask to view jobs they’ve already completed to make sure you like their work. (You must work with a general contractor when you borrow money through these products — you can’t be the general contractor.)
“You have to decide on the contractor before the loan closes,” says Cara Ameer. “You go to the lender with your purchase contract and they refer you to their approved list of contractors. If you have a contractor in mind who you want to use, they have to apply to be approved by that lender.”
How do the FHA 203(k) and HomeStyle loans differ?
FHA 203(k) loans require a 3.5% down payment, and you can borrow up to the FHA loan limit in your county. HomeStyle loans, on the other hand, require a 5% down payment, and you can borrow up to the Fannie Mae conventional loan limits. With a HomeStyle loan, you’re also able to finance renovations costing up to 50% of the completed appraised value.
While the FHA 203(k) and the HomeStyle loans both allow you to borrow up to a value that’s supported by the comps, the FHA Streamlined 203(k) allows financing only up to $35,000 into the mortgage for repairs and improvements.
While a contractor’s bid is required for most (if not all) of the work, “If you’re going to do things yourself, the only program that allows that is the FHA 203(k), and it would only be allowed for minor repairs — small-dollar-size repairs where the customer can provide evidence that they’ve the time, tools, and the assets to do the renovations,” says Bill Trees.
HomeStyle loans, on the other hand, don’t allow for any do-it-yourself repairs. However, while they allow borrowers to make the same renovations as in a FHA 203(k) loan, they also allow for the addition of luxury items.
Bottom line: If you plan to buy a fixer-upper using these products, it’s very important that you work with a home mortgage consultant who understands this product. They can help guide you through the process, which can be complicated.