All About Renovation Loans

Since buying Danascara, we have received so many questions about the HomeStyle renovation loan we used, why we used it, and how it works. I wanted to put together a quick rundown about renovation loans in general and then talk about our experience with using a renovation loan.

There were two different types of renovation loans available when we applied — the FHA 203K and Fannie Mae’s Homestyle Loan (the one we ultimately chose). In June 2019, Freddie Mac released the CHOICERenovation Loan, so I’ll go over that, too.

In addition to what we knew about the loans from our lender, I found a lot of my information for this post from Lending Tree and NerdWallet so please click the links under the titles for those full rundowns. I also had two mortgage friends who work in the mortgage industry look this over — Thank you to Christa and Sophie!

FOR ALL THREE:

You can use the loan to roll the cost of renovations into a new mortgage. In other words, you can take out the money for all the renovations and the cost of the home in one loan.

You can also use the loans to make repairs/renovations on a home you already own.

The renovation costs can cover mortgage payments if the house is uninhabitable during renovations.

Credit scores are set by the lenders that offer these loans. Think of the lender as the store; FHA, Fannie Mae and Freddie Mac as the manufacturers; and the loans themselves as the products.

Improvements must be completed by a licensed contractor and are subject to approval by an appraiser sent by the lender.

There is some possibility of doing a small portion of the work yourself for each of these loan types, but, in short, it makes the process more complicated. Also, different lenders have different rules about DIY work — some refusing it altogether.

Down payments will vary based on your credit score. All loans require mortgage insurance if you give less than a 20% down payment.

Cannot be used to tear down a house and rebuild on the foundation.

 

The 203(k) Loan – Guaranteed by the Federal Housing Administration

Sources: Lending Tree and NerdWallet

There are two types of 203(k) loans:

Limited (streamline): provides up to 35,000, but structural repairs are not eligible.  Standard: must finance at least 5,000 of repairs, but structural repairs are allowed (the maximum amount varies, see below). The standard 203(k) requires a HUD consultant to oversee the project — HUD provides a database to find these consultants here.

Credit score: At least 580 to qualify for this loan (though some lenders have a higher minimum of 620-640).

Down payment: Minimum down payment of 3.5% if your credit score is 580 or higher. (10% if credit is between 500 and 579).

Contingency reserve: The requirements vary based on a variety of factors including the age of the home, what type of damage it has, and whether you are using the standard or limited version of the 203k. The loan underwriter (who works for your lender) makes the final decision — it is usually between 10-20%.

Maximum loan amount: There are limits depending on where you live (find them here). Within those limits, you can borrow up to 110 percent of the property’s proposed future value.

How long you have to complete the work after closing: 6 months* (these timelines are often lender-specific)

Can you do the work yourself?

Short answer: it depends on the lender. Long answer: Some lenders say, “no way.” Others will require a contingency to protect against unforeseen problems, others require you to get a bid from a licensed contractor and then borrow that amount just in case you can’t complete the work. According to HUD, who makes the rules for the FHA loan, you have to write a letter explaining how you are qualified to do the work, you must have the time to do the work (work hours are taken into account), you must have your own tools, you must have the proper licenses where required, and you won’t get paid for your labor. Plus, no materials funds will be released prior to the work being completed, so you will have to pay for all the materials up front and be reimbursed after it is inspected.

Other notes:

As with all FHA loans, you will pay mortgage insurance regardless of your down payment amount. This is an extra cost added to your mortgage each month.

You can not use a 203(k) for investment properties or second homes. You can, however, use this loan program for more than just single-family residences. Primary residences that include up to 4-units are eligible.

The 203(k) loan does not allow improvements deemed “luxuries” like adding a swimming pool or an outdoor kitchen. You can repair an existing swimming pool.

 

The HomeStyle Loan – Guaranteed by Fannie Mae

Sources: Lending Tree and NerdWallet

Credit score: Most lenders require a credit score of at least 620

Down payment: 5% minimum for primary, single-family residence (10% for second homes or 3% for first-time home buyers.)

Contingency reserve: Required minimum of 10%, optional up to 15%

Maximum loan amount: The maximum loan amount is up to the maximum percentage allowed (97%, 95% or 90% based on the circumstances above in the “down payment” section). The maximum RENOVATION amount is capped at 75% of the final appraised value (i.e. if the final appraised value is $400,000 the most amount of funds available for renovation would be $300,000. Meaning you can’t buy a property for $100,000 and want to do $500,000 would of work and get financing for that full amount).

How long you have to complete the work after closing: 12 months* (these timelines are often lender-specific)

Can you do the work  yourself?

You can do projects yourself, but the DIY financing cannot exceed 10& of the completed value of the final project, and is only allowed on one-unit owner occupied homes. Again, you have to be reimbursed for the materials costs after the work is completed, and you don’t get paid any labor. (There are usually lender-specific guidelines for this.)

 

The CHOICERenovation Loan – Guaranteed by Freddie Mac

Sources: NerdWallet

Credit score: The required credit score is usually 660.

Down payment: As low as 3% depending on your credit score.

Contingency reserve: Required minimum of 10%

Maximum loan amount: Limited to 75% of the “as-completed” appraised value of the property

How long you have to complete the work after closing: 12 months (these timelines are often lender-specific)

Can you do the work yourself?

This loan does allow for some DIY when combined with Freddie Mac’s Home Possible program for first-time homebuyers. The work and your qualifications have to meet approval by the lender, and you can earn a credit toward your down payment and closing costs with this “sweat equity” work.

THE PROCESS:

  1. Apply for pre-approval through a lender who offers one or more of these renovation loans or through a mortgage broker.
  2. Hire a HUD consultant if you’re using a 203k loan (you can also hire a HUD consultant for the other renovation loans — some lenders may require it if the cost of renovations exceeds $50,000 or if there are going to be structural repairs)
  3. If you are going to purchase a house and roll the mortgage and renovation costs into one payment, then you should bring a contractor with you to view the house. You have to have at least a rough idea of how much the renovation costs will be before you make an offer on the house. Your purchase price PLUS the cost of renovations will be your total mortgage amount. This amount should not be more than the house is worth in the current market (and the bank won’t approve the loan if it is).
  4. Make an offer on the home and have it accepted. (Not always easy! You may have to try this with more than one property.)
  5. Work with your contractor to create written estimates for the work to be done. Your contractor will know the cost of most materials and include the labor costs. Labor and materials costs should be clearly labeled. In some cases you will have to choose materials — bathroom and kitchen finishes for example — to include on the materials lists. Make sure you talk through every detail with your contractor during this phase because this will be the outline for the entire project. It will also be the most accurate final cost list unless unforeseen issues arise. You will also decide on the number of draws you want your renovation costs to be disbursed in — we had a choice between 2 and 5 and chose 3.
  6. Your list will be submitted to the lender for approval. An appraiser will also be scheduled — he or she will come out and view the house to determine what the final value will be once the renovations are complete.
  7. Once the work list is approved and all other paperwork is in order, a closing can be scheduled.
  8. Close on the house. Purchase price will be paid out to the seller and renovation costs will be put in an escrow account. For 203k loans the funds are handled by the HUD consultant, if you have one. For other loans, you will receive contact information for a loan officer/draw administrator who will be your source for any questions and the person you call each time you need a new inspection/draw.
  9. The first draw is disbursed — you and your contractor must sign it and your contractor must cash it/deposit it to use. The first draw for us was half of the total materials cost.
  10. Our contractor worked to complete as many projects as he could on that payment, and once he had a number of projects finished he asked us to schedule the first inspection.
  11. The inspector looks at the work that has been done, and if it is done to his satisfaction, the next draw is disbursed. We found this process very quick and painless — our inspector wasn’t a huge stickler — he just wanted to make sure the work was being done to protect US from paying money out for work that wasn’t being completed. The check was always overnighted as soon as the loan officer we were working with received the paperwork from the inspector — usually the next business day.
  12. The project will go on like this until the last inspection, which is done by an appraiser again. The appraiser’s job here is to make sure all the work on the list has been completed, and assess what the house is worth at that point.
  13. Once approved by the appraiser, the last draw can be disbursed.

Notes:

Change orders will need to be submitted if you’d like to add on any projects. We did not have to submit change orders to take projects OFF the list — the funds allocated for that work was just rolled over into our contingency account.

To access our contingency account we had to submit receipts for the work that had gone over budget to the appraiser at the final inspection. He sent this information to the draw administrator we were working with and she approved the disbursement of our contingency money.

 

SPECIFIC QUESTIONS I RECEIVED:

Does the home value before and after renovations matter? 

YES, it definitely matters. Generally, your renovations + purchase price can not exceed the value of the house after it is renovated.

Do they cover any upgrades you want or just the basics to get the house livable?

The 203(k) loans have limits on what is covered — they generally don’t cover luxury items — but the HomeStyle and CHOICERenovation loans are very broad in what projects they will cover. Generally they will cover anything that is “permanently affixed” to the property, including appliances and landscaping.

Can you use these loans for any property — second homes and investment properties as well as primary residences?

The 203k is for primary residences — you can use it on a multi-family property if you are living in one unit yourself. The HomeStyle and CHOICERenovation loans can be used on accessory dwellings, second homes, and investment properties.

How does one qualify to even get one? Are there different qualification requirements than conventional in terms of income/credit scores?

Qualifications are based on credit score and debt to income ratio, just like any other mortgage loan. The minimum credit scores and down payments are similar to non-renovation home mortgage loans. As with non-renovation loans — FHA loans (the 203(k)) typically require a lower credit score and down payment than conventional loans (the HomeStyle and CHOICERenovation).

How did you decide what you wanted to complete with the reno loan and what could wait?

This was an easy decision for us — we wanted to borrow the least possible amount. We only included projects that we “needed” to finish to make the house livable (and insurable! — aka – safe) on the renovation list. An example of where we drew the line — light fixtures are necessary for a livable house, freshly painted walls are not (in most cases). So we had the cost of buying (some) and installing (all) light fixtures included in our renovation costs, even though normally that would come after all the caulking and patching and painting that also needed to be done. We didn’t want to add thousands of dollars to our debt when those are jobs we can easily do ourselves. The fact that we like to DIY our home projects was a big factor in the things we left out of the renovation loan.

What are they good for?

They are good for a variety of situations! If you are considering a house that needs a lot of work, they allow you to get all that work done up front and roll the costs into your mortgage. If you are already in your home and it needs a major renovation, you can refinance with a renovation loan and have it all included in one mortgage payment. They also provide a contingency that protects you in case your renovations go over budget.

Do only some houses qualify? Are there stipulations on work that has to be done? Does the lender require their approval of the completed work?

The FHA 203(k) has restrictions on what type of house can qualify, but most houses will generally qualify for the other two. You will have an appraiser come out after you submit your list of what you want to do, and that appraiser will say if there is something that “needs” to be done for the house to be of value to the bank after it is completed. Generally these are very important things like having a working electrical or plumbing system. Other than that, you choose which projects you do and you choose all materials and finishes yourself. All work must be inspected by someone sent by the lender after it is finished.

Timing. If you’re in a fast-moving market, is the reno loan too slow to be competitive?

Pre-approval for a renovation loan is just like pre-approval for a regular loan. You will need to gather all the paperwork necessary — taxes, pay stubs, bank statements, etc. — and get pre-approved with a specific lender or a mortgage broker. After that, you can make an offer on a house just as fast as another person — you just have to have some general idea of how much repairs would cost before you make your offer. Remember, the final mortgage amount will be the purchase price plus the renovation cost. If you’re in a very competitive market, I would find a contractor you trust, who is willing to go with you to house viewings, and bring him/her when you see a promising property so you can get even rough renovation estimates right away and have an idea of what kind of offer to make. The renovation loans are a longer process after the buyer has accepted your offer on the house and you are under contract because there is more paperwork (outlined above).

Do you need to have a committed contractor and bid before offering on house and loan?

You don’t need to but you should have some idea of how much the renovations are going to cost before you make an offer on the house. I would recommend having a committed contractor before you offer.

How to find reputable and reliable and reasonable contractors!

Preferably, work with someone you’ve worked with before, know and trust, or someone who comes recommended from friends or family members. Definitely try to find a contractor who has worked with renovation loans before — that was extremely helpful for us. Ask for references if you don’t know the person, and definitely bring them with you to view the house to get an idea of how they communicate and what their costs are. Remember, you also need a general idea of what renovations would cost before you decide on what you’re going to offer to purchase the house.

How specific do you have to be? For example, is it getting money to install the lights or install 15 lights? 

You need to be pretty specific, just so the final costs will be correct — materials and labor. I listed out exactly what products I was using just to know the exact costs, and so the contractor would know what he needed to charge for labor. The lender doesn’t generally care if you switch out the products during the process, but the costs have to add up to the final amount they are set to disburse and the general projects they gave money for have to be completed.

And can you do additions?

Yes (per approval of the specific project by the lender, as with all projects). The cost of the project can’t exceed the market value of the house.

 

 

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