When we first looked at this property we quickly realized that it was not habitable
None of the major systems worked (HVAC, plumbing, roof), and there was no kitchen. These issues are a big deal when it comes to financing, as a bank will typically not originate loans for properties appraised with condition codes of C5 or C6 (per the uniform appraisal dataset definitions). The minimum standard for a conventional mortgage is condition code C4 as follows:
The improvements feature some minor deferred maintenance and are in need of some significant repairs. Some building components have been adequately maintained and are functionally adequate.
Since our choice property is worse than the above definition, and we don’t have the capital to buy and renovate the property with cash, I was worried that this was just not going to be a feasible project for us.
Fortunately, I did some research and found that there are several government-backed renovation loan programs available in the US. Both Fannie and Freddie, as well as the Department of Housing and Urban Development (HUD) buy mortgages from banks meeting specific criteria for the purpose of buying and renovating properties in disrepair. However, these loans can’t be used to buy, tear-down, and rebuild a new home. They also come with a litany of rules, and typically a slightly higher interest rate (anywhere from 12.5-100 basis points above conventional).
The three programs we have highlighted below generally follow the same sequence of steps for the borrower:
- Find a participating lender and apply for the loan (i.e. get pre-approval for the amount you’d like to spend)
- Find a property (we actually did this first)
- Get a Home Loan Consultant (the bank will help you out on this)
- Get contractor bids and decide which contractor you want to work with
- Transmit information about purchase price and improvement costs to lender
- Bank will have an appraisal done both with and without improvements
- After the appraisal has been accepted the loan can close and the improvement funds are held in escrow and drawn against as work is completed
- Once the work is verified to be complete, any remaining funds in escrow can either be refunded or applied to the loan principal.
As far as which program to go with, it depends on how extensive (and expensive) the renovations are, what type of property (primary, secondary, investment), as well as which banks will extend these types of loans.
Loan Process
Find a Lender
Find a participating lender and apply for the loan to get pre-approval for the amount you’d like to spend.
Find a Property
Search for a property that needs some work. Keep your lender up to date on what's happening and when you've found a property.
Home Loan Consultant
These types of loans require someone to to verify that the work is being done according the to bid so that the contractor can get paid. Your lender will help you find this person.
Get Bids
Interview several general contractors and walk them through the scope of work you're interested in. Sometimes it is helpful to have had a home inspection to uncover issues you may not have seen, but would like the GC to address.
Transmit Info to Lender
Transmit information about purchase price and improvement costs to lender - this should be within your pre-approved loan amount.
Appraisal
Bank will coordinate with the HLC to have an appraisal done both with and without improvements. You'll need the detailed plans and bid for this!
Loan Closing
After the appraisal has been accepted and all other requirements have been met the loan can close and the improvement funds are held in escrow and drawn against as work is completed. The closing process takes longer than a traditional mortgage.
Wrap-up
Once the work is verified to be complete, any remaining funds in escrow can either be refunded or applied to the loan principal. The work must be completed within 6 months of closing.
Renovation Loan Programs
203k
As far as I can tell this was the first government-backed renovation loan offering. It is offered through participating HUD-approved lenders.
- Can be used only for primary residences.
- Minimum 3.5% down
- Flat-rate, non-dischargeable mortgage insurance required
- Renovation budget only constrained by conforming FHA limitations on the total size of the loan.
- 3-6% closing costs
- Lower credit scores can qualify
- Must live in the home post-renovation for a minimum of 12-months
ChoiceRenovation
This program was started in 2015 through Fannie Mae.
- Can be used for primary, secondary, or investment properties
- Minimum 10% down (can be as low as 5% in special cases)
- Dischargeable mortgage insurance after 20% equity built
- Maximum renovation budget of 75% of the as-completed value
- 10% renovation contingency requirement (can be financed)
- Offered in 15-year and 30-year terms
HomeStyle
This program was started in 2019 through Freddie Mac
- Can be used for primary, secondary, or investment properties
- Minimum 5% down for single-family primary residence.
- Dischargeable mortgage insurance after 20% equity built
- Maximum renovation budget of 75% of the as-completed value
- 10-20% renovation contingency requirement (can be financed)
- Offered in 15-year and 30-year terms