We all see the homes on the market listed as “fixer”, “cash and “lots of potential”. If approved for a traditional loan, you may overlook these properties believing that your lender will not approve these types of properties. You may think you need to have expendable cash to renovate these homes. Would it surprise you to know rehab loans tie both the purchase of a home and the renovation into one loan?  That you can leverage the bank’s money to update a home? That the loan to make the home your own starts low as 3.5% down?  

In a market where the housing inventory is so minimal, looking outside the box may be the answer to expanding search options. Today we are unboxing rehab loans.  What they are, how they work, and how they can make you competitive against cash buyers. If you are open to expending more energy than buying a move in ready home, these loans may be for you.

What are rehab loans?

Rehab loans combine the purchase of a home, or a refinance loan amount, with the costs to remodel, both into a 30 year fixed loan. These loans are also referred to as renovation loans.  The loans allows for anything that will add value and address any health and safety concerns.  Want to add a bathroom, a bedroom or remodel a kitchen in the house? Does the well or septic need to be updated? Maybe the foundation has an issue? Need to update old cracked windows, remove the lead based paint or remediate mold?  There are so many options!  Some stipulations do exist. Hot tubs, pools and anything considered as luxury items, are not allowable to be financed. 

The loans allow financing on single family homes and multi family homes. (Duplex’s, triplex’s and quadplex’s count as long as one of the units will be owner occupied.) A few of the loans additionally allow for securing second homes and single unit investment properties. Homes in the initial phase of construction, not approved by the city or county for occupancy, typically do not qualify for these rehab loans. In very specific cases, if the home is over 90% complete, a lender may be able to waive the new construction factor if a conventional or private rehab loan. Though to note, this is very loan type and lender specific.  In all cases, no manufactured homes of any nature, qualify.

How do Rehab Loans work? What is the Process?

The process of using a rehab loan is similar to purchasing with a traditional loan. There are though, a few complexities added to the process. Getting pre-qualified is always the first step.  If you know you will be renovating or remodeling a home, it is imperative that step two is finding a licensed and insured general contractor.  The contractor should be aware and okay of two things. One, logistics of working with a lender. Second, the contractor should become familiar with the lenders’ payment structure. It is typical for lenders to make payments a week or two after the inspector has approved the completed task. Often after after the builder has moved on to the next project.

One thing to note, if you are a licensed HVAC, electrical , plumbing contractor etc., you cannot do the work on the home yourself.  The general contractor you hire may be able to hire you, but this is something to be you will work with your lender for approval. 

Step three, now that you have a pre-approval and a contractor, it is time to start home shopping. Once found, offer on and get an acceptance from the seller. Your realtor will write an extended inspection window greater than the typical timeline of most purchases. This window gives you the opportunity to have your contractor out to the house. Together, you and your contractor will determine the work needed along with what you envision for the home.  The contractor will put together a bid for the costs expected and submit this to the lender.  The lender reviews the bid and requests for an appraiser to look over everything. After reviewing the land and bid proposals the appraiser will value the final project. If your loan is one of the two FHA 203ks loans, a HUD Consultant is also brought in to look over everything.

If the anticipated value is satisfactory, the loan process is then similar to a typical purchase. The underwriter reviews your loan and once approved, sends loan documents to title for you to sign for closing. The lender typically then requires work to start on the home within 30 days of closing. The lender prefers to have the process completed within 6 months. Though as we all know, if there is anything we can count on in the last two years, we can’t count on anything being normal.  Labor shortages, people getting sick, supply chains disrupted… everything may go as smooth as silk, or it may not. You may encounter stressful moments and should be aware or prepared.

The 4 Types of Rehab Loans

There are 4 types of Rehab loans. Two are FHA, the limited and the standard. There is then also the conventional and the private lending backed rehab loans.  

FHA Rehab Loan Options

The 1st two, the the limited and the standard, are FHA 203k loans. These loans require a minimum of 3.5% of the final loan amount put down at closing, plus closing costs.  These are held to standard FHA loan requirements. The loan must be your owner occupied property and have an occupancy permit filed with the city or county. (As long as you will live in one of the units, duplex’s, triplex’s and quadplex’s also qualify as owner occupied.) 

These loan must adhere to FHA loan limits allowed per the county the home is located in. Limits vary by county and how by many units there are in a property. Here in Yamhill County, the 2022 FHA Loan limit is $598,000 for a single family home.  The loan limits increase for 2, 3, and 4 unit homes.  In Polk county, the 2022 FHA Loan limit is $420,680 for a single family home. Again, max loan amounts rise for additional units.  Each year by the government calculates max loan values for each county. They are based on the median sales price per the county. You can find the loan amounts for your county at https://entp.hud.gov/idapp/html/hicostlook.cfm.  As a reminder, the final “loan amount” is inclusive of 3 things. The purchase price (or loan amount, if refinancing and live in the home), the repair budget and a small contingency, typically 10%,  in the event repairs go over budget.   

The FHA 203k  limited loan has an allowance of up to $35k in repairs. The FHA 203K standard loan, does not limit construction costs. You cannot though, exceed the max FHA loan set for the county the home is in. Being FHA (government) backed, a HUD consultant is more often than not, required to be involved as well. The HUD consultant reviews the contractors bid amounts, considers the appraisers appraisal and notes, and determines two things. First, are there additional requirements that need to be taken care of during the renovation that are not already addressed? Second, confirms that the time and cost quoted by the contractor are realistic for the job being done.  Having the HUD consultant does add a small cost to the final closing figures and can be quoted by your lender, for your specific area.

Conventional Rehab Loan

A third variation of the rehab loans is the conventional.  This loan requires a minimum of 5% down at closing, plus closing costs if owner occupied. Again, this can be one to four units, as long as one of the units will be owner occupied. You can finance 2nd homes, with 10% down. With 15% down, you can also use the rehab loans for single dwelling investment purchases.  Not being government backed like the FHA loans, the HUD consultant is not a required. Loan limits for conventional loans are a bit higher than FHA loans. Most of the nation allows a conforming loan limit for single residences of $647,200 for 2022.  Similar to FHA Loans, the loan limit increases depending on the type of property and how many units there are. You can locate your county at https://www.fhfa.gov/DataTools/Tools/Pages/Conforming-Loan-Limits-Map.aspx.

Private Rehab Loans

The 4th variation of rehab loans is a privately backed lender. These loans vary in all aspects. Variations are present dependent on the private lender backing the loan or the group of private investment lenders. Terms, rates and allowances will very lender to lender.

As you can surmise, these loans produce more risk for the lender than traditional loans. Lenders front more money at closing than the home is worth. Sometimes, the property may not even be in a habitable state.  Due to this, rates are a hair higher in these programs and there are a few additional fees at closing.  You also need to carry a builders risk insurance policy during the course of construction. These policies may run a bit higher than normal home insurance as well.

Closing Funds

What if you have the money to put down, but possibly not all the additional closing costs as well?   Another unique feature of these loans, the allowance to be up to 110% of the purchase price plus rehab costs. Or too, 110% of the expected future appraised value, whichever is less. (This is the amount the appraiser values the home will be worth after completion.)  As long as the loan does not exceed your pre-approval amount, nor the stated maximum loan limit, you may be able to add your closing costs into the loan.

How to Beat a Cash Buyer

Another thing the higher percentage may allow for is wiggle room on your purchase offer amount. By increasing your offer, you may be able to beat out another buyer’s offer. Many times the cost put into renovating a home, is less than the final equity value acquired. As an example, let’s say you want to buy a home that needs work, listed for $300k.  You and your contractor determine you need to put $100k into the home.  Your loan amount then is around $400k.  Your realtor informs you and your lender that ready updated comparable homes, are being listed for $450k. As long as you stay under what your lender originally pre-qualified you for,  you could bump your offer up. Let’s say you offer $330k to possibly beat out the ‘best deal finders’. Adding the $100k in repairs, your loan amount is then in the window of $430k. Based on your realtors evaluation, you are still likely to have more equity in the home at completion, than what you put in.

It is common to note, many times when buyers purchase rehab homes, especially cash buyers, they are trying to get the best deal they can. Many have limited funds they are working with. Investors often have limited funds and small windows of time to flip a home, before the costs of a project start eating into their profit.  In essence, what this does then, is make you more competitive against cash buyers, because you are not working under the constraints of limited cash or time and can offer more to entice the seller. 

In Summary

As you can see there are a LOT of variables in these loan programs. The rehab loans are very Niche. Though most lenders offer 1 or 2 of the variables, finding a lender that is proficient in rehab loans, or even better, has made rehab loans their specialty, will make for a much less stressful transaction.  If you are in Oregon and need a referral, let me know, I can get you in contact with one. The nice thing about having your rehab loan specialist, you will not need to remember everything on your own. Between your lender, realtor and contractor, you will have a team guiding you through the process. So go out, find the ugliest house on the market! Find your diamond in the rough and remember, with a bit more energy, instead of settling for what is on the market, you may be able to not only buy an updated home, but tailor it to your likings!

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