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What is a rehab loan?


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Unless you're among the famous or fabulously wealthy, it's unlikely you have enough money to pay for a house in cash. Mortgages are incredibly common when it comes to paying for your home, but what if you want to buy a fixer-upper? How can you swing enough cash to buy a home and renovate? Perhaps you've heard the term and have been wondering: what is a rehab loan? How does it work? Enter the FHA 203k loan – a mortgage option for those who want to buy and renovate.

Renovating my first home was a difficult process: I talk a lot about home-buying mistakes, but I haven't discussed where all of the money to completely renovate a home came from. This post covers not only what the 203k renovation loan product is, my own experiences using an FHA 203k loan, and my advice for other first-time home buyers who are considering it.

What is a rehab loan?

A “rehab loan” is a more common/popular term for what's known in lending circles as the 203k renovation loan — a mortgage product where you can borrow money for home renovations at the same time you borrow money for a mortgage and it lumps the funds all together as one mortgage loan.

  • Using my first home as an example, when I first applied for a mortgage, I was qualified for up to $130,000 as a single woman making $40,000 annually.
  • I could either do a traditional mortgage and buy a home for $130k, but if I wanted to buy a fixer-upper, and borrow bank money to do it, I'd need to buy a home for less than $130k and factor in the amount I'd need to borrow while keeping in mind that $130k max.
  • So for me, I bought a home for $65k and borrowed $58,000 to renovate for a total of $123,000.

Each month I made my mortgage payment and paid off the full amount. There is no discernible difference in your account between mortgage and renovation loan money, once the loan gets funded it is all just one lump sump.

Is the 203k an FHA Loan?

Yes. 203k loans are insured by the Federal Housing Administration, making them less risky to lenders. As such, they're easier to qualify for than a traditional construction loan and come with the same income and credit limits as an FHA loan.

You don't have to get a 203k to buy and renovate a home, it's just one type of rehab loan product. There are also other rehab loan products, such as the Homestyle Renovation Mortgage, and Choice Renovation Loan, among others, but most loans dictate you have to live in the house as your primary residence to qualify.

Okay, but what is an FHA Loan?

FHA loans are mortgages insured by the Federal Housing Administration.

FHA loans require smaller down-payments and have less restrictive lending standards, making them more attainable than other financing options. Perfect for first-time buyers who may not have perfect credit, finances, or a large downpayment.

Pros: 

  • If you don't have the best credit, an FHA loan might be the best way to go. As long as you have a credit score greater than 500, you can apply. If you want to have a small down payment, you'll need a 580 or better score.
  • Perhaps the most appealing part of an FHA loan is that you can pay 3.5% for a down payment. This is a huge difference compared to the 20% required for most conventional loans.
  • For example, if you've found your dream house, and the asking price is $200,000, with a conventional loan, you'd have to pay a $40,000 down payment. But with an FHA loan, your down payment would only be $7,000.

Cons:

  • Because you're putting less than 20% down on the home, the bank views you (the buyer) as a higher “risk” lendee.
  • For this reason, they charge you a “fee” for the lower down payment. This “fee” is called private mortgage insurance, and it's tacked onto each monthly mortgage payment.
  • Having PMI means your monthly payments will be slightly higher, but you'll be able to get into a home sooner than waiting to save up 20% for a conventional loan.

How the FHA Operates

The Federal Housing Administration is a mortgage insurer, not a lender. The only difference between an FHA loan and a conventional mortgage (aside from the requirements) is that these loans are guaranteed by the government. The government does this to spur economic development and encourage homeownership. How nice of them.

You'll still have to shop around to find the best underwriting, services, and costs with an FHA loan the way you would with any other mortgage product. Consider looking at both lenders and mortgage brokers, as what they can offer will vary.

How does a rehab loan work?

First, there are two different types of 203ks.

  • The Standard 203k – For loans over $35,000 with more extensive projects like total remodels, structural work, etc.
  • The Streamlined 203k – For more cosmetic-type projects (countertops, flooring, paint) and renovation work totaling less than $35,000.

I found out about the 203k loan product via my mortgage broker, who suggested it at the same time he suggested the downpayment assistance programs. He knew that a lot of the homes in the zip codes eligible for assistance needed a ton of work, and looking at my financials, he knew I didn't have the cash on hand.

How does the rehab loan process work?

You apply for a rehab loan/mortgage in the same way you apply for all other mortgages:

  • You shop for an interest rate and lock your rate in
  • Then select a lender
  • You get a pre-approval letter from your lender which allows you to shop for a home.
  • Once you find the home you want and make an offer that gets accepted, you'll then apply for the mortgage with that lender
  • You get conditionally approved for the mortgage and your loan goes into underwriting
  • The lender sets a closing date
  • At closing, the bank wires the money to the home seller for the amount of the property. You sign paperwork and become a homeowner.

 

How is rehab loan financing different than a traditional mortgage?

  • Because you're buying a fixer-upper and borrowing the money to do renovations upfront, you'll need to know how much you need.
  • In between finding a home you like and making an offer, you'll get in touch with a contractor who will come out and give you a bid (estimate) for all the work. (I suggest doing this before you make an offer on the home because as a beginner, you may not know all the things the house needs. If it needs more work than you thought, you can try and negotiate the price. )
  • The contractor makes a bid.
  • Offer and acceptance.
  • Then your real estate agent will send both the standard purchase agreement and offer letter with the contractor's bid to the bank. This lets the lender know how much your final loan amount will be in.

The bank won't push back on the amount so long as it comes in under the maximum amount you've been qualified for.

How can I qualify for an FHA 203k Loan?

You must be planning to live in the home as your primary residence. This loan product isn't for the HGTV set or individuals who want to start real estate investing.

  • A standard FHA loan will take credit scores down to 580. For a 203k shoot for a higher score, between 620-640.
  • Rehab must be at least $5,000 in value, but the after-project home value cannot exceed the current FHA loan limit of that area. (FHA Loan limits vary by county and state.)
  • You can borrow up to 100% of the home's future value. Using the bid from the contractor, the bank will come and do an appraisal on the home and come up with how much the home will be worth once the work is complete.

What else do I need to know about the rehab loan/203k loan process?

  • The biggest thing people are surprised about a 203k loan is that you never see the money used for renovations. It's not like a cash-out refinance or a home equity line of credit. There are serious rules and regulations in place to ensure money is not abused.
  • Lenders require a third-party FHA consultant. Basically, this is a third party who oversees the work on the home. You will pay for this consultant out of pocket. (Mine charged me $600 for the project.)
  • Upon closing, the money gets delivered into an escrow account. In my case, I had my own specialist at Wells Fargo overseeing it and communicating with me about it.

Check-ins and payout dates may vary depending on the size of the loan and the scope of work.

  • In my case, there were four pre-determined check-in and payout dates. The contractor is expected to have certain amounts of work done by each check-in date.
  • The FHA 203k consultant would come out and inspect to make sure work was done, send a form to my bank and then my specialist at the bank would verify with me via email and if all was good, cut a check for 1/4 the amount of the whole project and make it out just to my contractor.
  • The check would get overnighted to me to sign and give to the contractor, but I never had control of the money or access to it directly, which I actually liked. There are checks and balances in place to make sure funds do not get misused.

That's not to say it's a flawless system, but more on that later.

Benefits of a using rehab loan

  • Many first time buyers have a hard time swinging a down payment, much fewer thousands of dollars for a renovation job. So, a rehab loan makes this possible.
  • I also liked being able to have the home exactly the way I liked it.
  • There are also stipulations and timeliness built into the loan, depending on which one you choose — if the contractor wants the money, work has to start within 30 days of the loan closing and be completed within six months of work start date.
  • Money for renovations at rock-bottom mortgage loan prices – you don't have to use higher-interest credit cards or personal loans to fund the project.

Disadvantages of using a rehab loan

  • Because of all the paperwork and communication about payment and inspection dates involved, you have to start and end the project with the same contractor. If you disagree with your contractor or don't like his work, this can create multiple issues. (At least, this was how it went in my case over ten years ago. This stipulation could have changed.)
  • The project amount is set in advance, so you can't change the payment amounts once work starts. Not even to add work. This means it is to the contractor's benefit to do cheap work so they can pocket larger margins. (Been there, too.)
  • And in doing my research back then when things did go south on the project, when using this loan/product there are very few resources or avenues of recourse if something does go wrong. It's either stop the work and halt progress on your project while you fight it out between, your contractor, the consultant, and the bank or keep it moving and try to get your money back later.

Using a 203k loan may make it hard to find quality 203k contractors to work with.

  • For the first part of the project, the contractor is working “on credit” – meaning they don't get any money up front to start work or pay for supplies.
  • This is why many contractors don't like to work with homeowners using 203k loans since it can be a hassle on their end to get paid.
  • I also think having access to such a large amount of money leads people to borrow more than they can afford in their attempts to make the home of their choice perfect.
  • Be sure when accounting for mortgage + renovation loan to still get a loan at a price point your monthly budget can comfortably afford.

What is a rehab loan? My best advice

Do the streamlined 203k and not the full. As a first-time buyer, you have no business buying a home that needs that much work. If I had to do it all over again, I'd probably go this route or have chosen a different home altogether. 

Rehab loans often have stricter eligibility requirements compared to regular home loans. Lenders may require a higher credit score, a lower debt-to-income ratio, and a more substantial financial history. If you don't meet these requirements, you may not qualify for a rehab loan.

Lastly, it's important to note that rehab loans are typically designed for primary residences and not for investment properties. So if you're planning to use the loan for a property you intend to rent out or sell, you may not be eligible for a rehab loan.

BUT if you're looking to renovate (or need to buy a fixer-upper just to enter your market in these high-interest rate times), rehab loans are an excellent way to find the money to make necessary repairs at some of the cheapest costs to borrow.

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