Have you found that “almost perfect” home in the right location that is selling at a reduced price because it needs a little rehab work? Did the listing have those magic words…”203k loan recommended”.
Unfortunately, most mortgage loan programs require homes “in need of work” to be complete before the financing can be secured for the purchase transaction. In today’s market, more homes “need work” than don’t. Most buyers do not have the luxury of completing minor repairs before they can actually move in.
Whether the property needs a little or a lot of work, most First-Time Home Buyers simply don’t have the up-front cash to invest in a property prior to actually securing the financing.
This is not a new problem, and there are ways to accomplish the purchase. If you dig a little deeper, or deal with an agent that has more than a handful of gimme and mouth full of much obliged in his bag, you will discover where there is a will, there is a way.
The FHA 203(k) Rehab Loan may be your answer to turning that “fixer-upper” into your dream home.
The FHA 203(k) Rehab Loan is a popular mortgage program designed for buyers that want to finance the cost of home improvements into a new loan. You can actually seriously consider a home that needs repairs.
The financing for this loan will include the purchase price, as well as the improvements you are either required to do to be able to live in the home, or that you want to do, such as upgrade the kitchen, bathroom, etc.
This is also a great loan program for agents trying to sell homes that need repair. Buyers will have an option to complete those repairs and upgrades without a large upfront financial commitment.
Think of this as a one-time close construction loan.
At closing, the seller receives their money and the rest is put into an escrow account for the buyer to use for rehabbing the property.
Advantages of 203k Rehab Loans:
Repairs on a fixer-upper can be expensive, and the 203k Rehab Loan allows borrowers to finance the improvements into the new loan vs having to pay for the upgrades prior to closing.
Low Interest Rates:
Historically, FHA Mortgage Loans have lower than average rates when compared to commercial or conventional financing programs.
Great Property Deals:
Since Rehab Loans are designed for “fixer-uppers,” buyers can qualify for a loan on a home that needs work, and actually finance the construction costs / repairs up front.
FHA Rehab Loan Background:
The Federal Housing Administration (FHA), which is part of the Department of Housing and Urban Development (HUD), offers a loan program to provide for the rehabilitation and repair of single family properties.
One single loan is used to pay for the purchase (or refinance) and the cost of rehabilitation or updating of the home.
Those properties include condominiums, town homes and single family homes. This loan is only available for home buyers purchasing a primary residence that they will occupy.
Unfortunately, it is not a program for investors to purchase a home – fix it up – and then sell.
As you can imagine, there are vastly different degrees of just how much work it would take to bring a house up to your standards.
Sometimes it may only require minor cosmetic work, like new flooring, upgrade a kitchen or bath, put on a new roof or install new windows…you get the idea. Or it could be that you find a home that is the perfect price and location, but inside it needs a complete gut job.
You like the shell of the house but want to blow out the walls to change the floor plan, need to totally re-do plumbing, electrical…major stuff! Maybe the bones of the house are terrific but it is just too small…you need to add an extra bedroom or even an entire new level!
The FHA 203(k) Rehabilitation program, (we’ll call it…the K) is designed to address all of these circumstances.
Another great thing about both of these loan programs is that they are originated and underwritten just like a standard FHA loan program.
So you can purchase the home with the same 3.5% down payment of a regular FHA loan, depending on your loan amount. In some high cost areas the down payment may be 5%, but there is no larger down payment required on a 203(k) than there is on the regular FHA loan program. And the seller can also still assist you with your closing cost as well…just like with a regular FHA loan.
203(k) Rehab Loans Eligible Property Types:
The property has to have been completed for at least one year, and it has to be a one- to four- family dwelling.
You can use the program to convert a one family dwelling to a two-, three-, or a maximum of four family dwelling.
Eligible property types are single family detached homes, single family attached (like row houses) town homes and condominiums. Cooperatives (Co-ops) are not allowed.
The program will let you “pop the top”…find a single story home and add a new level, take a home…demolish it (at least a portion of the foundation must remain) and build a brand new home in its place, and even take an existing house (or modular unit) from one location and move it to a new location.
That’s pretty cool!!
Let’s take a look at a perfect scenario:
You find this great house that is in the perfect location, close to transportation, great school district, excellent floor plan and the yard you always wanted. It’s the lowest price in the neighborhood.
So what’s not to like?
It’s a foreclosure.
And, the last occupant decided to just destroy the house before they left – taking all the appliances, ripped up the carpet, punched holes in the walls, broke windows…. They even took a toilet with them! Who takes a toilet?
Can you imagine fixing all of that?
Most first-time home buyers just turn around and walk out the door because they believe they couldn’t possibly come up with the money or the time to fix all of this.
So, a really great house goes unsold.
Two Types Of FHA 203(k) Loans:
- The Streamlined K is used when you want to make minor cosmetic changes to a house and the total rehab cost can not exceed $35,000.
- A Standard FHA 203(k) loan allows you to make substantial structural improvements, repairs, remodeling and updating to a house…even build a new one.
A Streamlined 203(k) allows minimum or limited repairs to be done…basically “cosmetic” repairs, improvements or updates.
It also eliminates most of the paperwork required of a full 203(k) and simplifies the process to obtain rehab funds.
Under the Streamlined program, there is a minimum of $5,000 and a maximum of $35,000 to be financed in the mortgage amount to improve or upgrade the home.
No “structural repairs” are allowed under a Streamlined K, however, making or correcting any structural items is not considered to be minor.
The minimum of $5,000 of required and substantial improvements that will increase the marketability and value of the home must first be included. Any repairs and improvements must comply with HUD’s Minimum Property Standards and must meet all local building, zoning and other codes.
Minimum required repairs include any health and safety repairs like peeling lead paint or replacing missing railings. Whether you want those items included or not, all health and safety issues must be addressed first. Smoke detectors must also be added if missing.
Type of work for Streamlined 203(k):
- Repair, Replace or Upgrade
- Roof, gutters, downspouts
- Existing HVAC systems
- Plumbing and electrical systems
- Repair, replace or add exterior decks, patios, porches
- Basement waterproofing
- Window and door replacement and exterior siding
- Septic and/or well repair or replacement
- Improvements for accessibility
- Lead-based paint stabilization or abatement of lead-based paint hazards
What can’t you do? Ineligible improvements under the Streamlined 203(k):
- Major structural repairs
- New construction (adding a room)
- Repair of structural damage
- Repairs requiring detailed plans and specs
- Any repair taking more than 6 months to complete
- Repairs that would necessitate more than 2 draws
- Luxury items that are not a permanent part of the real estate
- Granite, marble countertops, Jacuzzi tubs, hot tubs, pools for example
Let’s go through the process of the Streamlined 203(k):
Find the home you’ll want to purchase and determine what improvements need to be made to the property.
The purchase contract offer is written the same as any other, accept you’ll want to make sure that there is language stating the purchase is contingent upon borrower acquiring an FHA 203(k) Loan.
In order to complete the financing of the improvements, you will need to meet with a contractor to determine what kind of work you are planning and how much it will cost.
The contractor will give you a copy of the contract, which you’ll need to pass on to the lender.
The lender will order an appraisal to determine what the value of the house will be once all of this work is completed.
Keep in mind, you’ll also need to be qualified for the full loan amount which is based on the purchase price plus the additional cost of repairs.
Once the loan is approved, you will go to closing like you normally would.
The amount that will be needed to do all of these repairs or improvements will be placed into an escrow account held by the lender.
As the work is being completed, there will be draws from the account to pay the contractor.
What does the Contractor you select need to do?
- Provide written work plan and cost estimates
- Must include nature and type of repair and the cost of completion
- Must be licensed and bonded for each specialized repair
- Must agree in writing to complete the work for the amount of the cost estimate and within the allowed time
Let’s take a look at a quick Streamlined 203(k) example:
Say you need $20,000 to do all the improvements to the house. Most lenders will require a 10-20% contingency reserve account to be set up. This is money they will set aside for any “surprises” that may happen during the rehab. You don’t want to have something come up that you didn’t expect and then have no money to fix it.
So, in this example another $2,000 would be financed to establish your reserve fund.
A total of $22,000 is now available to be placed into the rehab escrow account.
Once you have completed settlement and own the house, the rehab account will be established and you will be able to start the work.
The contractor will request the first draw of up to 50% of his contract, which in this example is $10,000.
Once the work has been fully completed, he can request his final draw and receive the balance of his contract.
The money in the contingency reserve account is for emergency work. If down the road there was no need to use it and you decided to do some additional work to the house…you could then request a change order and spend that money, but it would not be paid out to the contractor until the final draw.
The reason this program is called a Streamline is because there are fewer draws, less paperwork and only cosmetic, minor repairs involved.
All work should be completed in 6 months or less.
Advantages of Streamlined 203(k):
A great advantage of the Streamlined 203(k) vs the Standard FHA 203(k) is that there is less paperwork.
Under the streamline, there is a maximum of two draws per contractor. It is easier if you have only one contractor, but a maximum of two contractors to do this level of work is allowed.
After you have gone to settlement and your loan has closed, the contractor will receive the first of two draws. They are usually permitted to get up to 50% of the materials (sometimes 50% of the total work amount) in this draw.
The remaining monies are given out once the project is completed and the work has been final inspected. The checks for each of these draws are made out to both you and your contractor.
Standard FHA 203(k):
If you have a larger project that needs a full gut job or additional rooms, the Standard FHA 203(k) is the right program.
This is what we refer to as the “full blown K”.
Under this section of the program, much more extensive repairs or remodeling can be accomplished.
The full K allows you to make “structural” changes to enlarge a house, build a new home on an existing foundation and even take an existing house and move it.
Unlike the Streamlined K, where the improvements are “cosmetic”, under the full blown K the repairs or improvements can be and usually are “substantial”.
So, you can imagine that the process is a bit more involved.
Think of it as a mini construction loan program where your contractor can ask for as many as 5 draws, and each draw request will need to have an inspector come out to make sure the work has been completed for that draw request prior to any monies being paid.
Because it is more involved than a standard loan, there are more costs involved.
Type of work for a Standard 203(k):
- Structural alterations and additions
- Attached unit (new)
- Remodeled kitchen and baths
- Changes to eliminate obsolescence and reduce maintenance
- Modernize plumbing, heating, AC and electrical systems
- Install or repair well or septic systems
- Roofing, gutters, downspouts
- Flooring, tiling and carpeting (to be included in the 1st $5,000, the condition must create a health and/or safety problem OR not meet HUD’s minimum appraisal standards
- Energy conservation improvements
- Major landscaping
- Improvements for accessibility
- New free standing appliances
- Interior and exterior
- Swimming Pool repairs (not to exceed $1,500)
- Other improvements that are a PERMANENT part of the real estate
*Luxury items are not permitted to be included in the financing.
What is different from the Streamlined K and the full FHA 203(k)?
The full K requires a HUD Consultant (selected from HUD’s approved consultant list) to be retained by you.
They will come to the property and meet with you to discuss the anticipated improvements you want to make to the house. They will inspect the property for any health and safety issues required to be included in the rehab and will then provide you with a “Work Write-up” for the project based on the work you would like to have done.
The HUD consultant is someone that is knowledgeable about construction and/ or rehab and who knows the 203(k) program.
What is the role of the HUD 203(k) consultant?
- To do a Feasibility Study on required repairs
- To do a Property Inspection/Report
- To work with you discussing your renovation needs
- To prepare a Work Write-up and any required architectural and/other exhibits
- To do Draw Inspections, Change Orders and Final Inspection
- To be a liaison between you, the lender and your contractor
- To insure that work is completed in a timely and professional manner
- To watch over the monies spent on behalf of you and your lender
Whew!!! That’s a lot of stuff…let’s get into the nuts and bolts of the full blown K.
What are these studies, write-ups (what’s included) that the consultant provides and what does this cost?
It is only a rough estimate of the work that needs to be done and what the cost should approximate. It costs $100 and can be one of the items you finance.
Not every property or borrower needs a feasibility study.
- Those appropriate exhibits which show the scope of the work to be done
- Plot Plan (only for new addition)
- Proposed Interior Plan, showing structural changes
- Work Write Up and Cost Estimates
- Home/Property Review Report (existing )
- Termite Report/ Well/Septic Report
- Energy Analysis or Home Energy Rating (for EEM)
- Proposed Plot Plan (for new additions)
- Proposed Floor Plan (with wall changes)
- Other reports/exhibits as necessary
- Work Write Up (description of work)
- Cost Estimates (detailed)
- Home Inspection Report – “Cornerstone of successful 203(k) loan”
- What’s wrong with the house?
- Note deficiencies and certify the condition of all systems
- Get wood boring insect report
- Focus on health and safety concerns
- Meet HUD’s Requirements for Existing Housing (4905.1)
Format for the Work Write-up
- There is no specific mandated format
- It must be prepared in categorical manner with 35 categories
- It must be detailed as to the work to be performed and costs
- It is recommended that it be done “room by room” as well as by category
- There should be a break down between labor and materials
- Based on R.S. Means, Marshall Swift or Home Tech estimating systems
- Don’t use low bid, because there must be enough money for any contractor to complete the work
- Must include labor and materials
- Don’t eliminate labor costs because borrower says he will do the work
- 10% to 20%
- If house is old or rehab is extensive
- Over 30 years old, must have at least 10%
- If utilities are off, must have 15%
- Savings from change order go into contingency
- At the end, contingency can pay for additional work or the changes
What are the Consultant costs associated with this?
- The consultant must be HUD approved and it’s typically $400 to $1000, depending on rehab cost
- There is also an inspection Fee – set by HOC – for maximum of 5 draw inspections – plus mileage
How are the Contractors paid?
There is no up-front money to the contractor on the full K vs the Streamlined. He receives his first draw check only after the work to be done under the draw schedule has been completed.
Contractors can have a maximum of 5 draws altogether. The HUD consultant will divide the work into draws depending on the scope of work to be done.
You may do the framing first, then the heating and electric, then the drywall for example. If each of those were in separate draw schedules, the contractor would get paid for each of those as they are completed and depending upon which draw they were to be counted in.
The consultant will go out to see that the work described under the first draw has been completed and will submit a request for that draw. For each of these draws a 10% contingency is held. Again, this is just to be sure there are no surprises and that all of the work is completed correctly.
So you can see that there is a difference in whether you use a Streamlined K or the standard FHA 203(k) loan.
Most foreclosed properties only require minor cosmetic repairs, so the Streamline is the way to go in most of those instances. Just make sure you have no structural improvements that need to be made if you are thinking of using the streamlined K.
Even if the repair would cost say $5,000 which falls into the less than $35,000 max for the streamline, you would have to go with the standard K just because the work is “structural”. So make sure you know which repairs you are planning to do before you decide which 203(k) would work best for you.
These are both great loans to use to find that “almost perfect” home and truly make it into your Dream Home. Not all lenders are able to do this loan however, as you can see they require a bit more attention once the loan has closed. So, be sure to ask for a lender that is well versed in Rehab Loans.