Renovation Loans: The Good, The Bad, and the Ugly

I'll start off by saying that most home renovations aren't completed with renovation loans. Most home renovations are completed using a home equity line of credit (HELOC), or with a cash-out refinance. Of these two, a cash-out refinance is probably the preferable option unless the renovation process will be especially long and drawn out. And in any case, following a major project a HELOC balance should always be paid down using a cash-out refinance, for three reasons:

1) A HELOC's interest rate is adjustable whereas a cash-out refinance's rate is fixed (or at least temporarily fixed).

2) When a HELOC's repayment period starts, usually ten years after the HELOC is opened, the credit line turns into a fully amortized loan, so the monthly payments can double or more.

3) Because of recent changes to the new tax code, interest paid on a HELOC is no longer tax deductable, whereas interest paid on a cash-out refinance is tax deductible (on loan amount of $750k or less).

That being said, this article is about a class of mortgages that's much more interesting than a standard HELOC or cash-out refi. It's about bonfide, renovation mortgages. There are three main varieties of these mortgages available:

1) The government insured, FHA, 203(k) program:

This program allows for a low, 3.5% minimum down payment and provides funds for both the purchase (or refinance), renovation and permanent financining of a 1 to 4 unit, owner-occupied property. Additionally, I work with lenders who can offer this program to borrowers who want to build a property from the ground up.

2) The conventional, Fannie Mae HomeStyle program:

This program provides funds for both the purchase (or refinance), renovation and permanent financing of a 1 to 4 unit, owner-occupied property, or the purchase (or refinance), renovation and permanent financing of a 1 unit investment property. While it requires a somewhat higher down payment than the FHA program, the mortgage insurance costs are generally better with HomeStyle, and the program has less restrictions than the 203(k) in terms of what kind of renovation can be done.

3) Business purpose or other non-conforming renovation or construction loans:

These loans are offered mainly to investors (on non-owner-occupied properties). They are also generally short-term loans, with terms no more than two years. At or before the end of the loan term, the borrower is required to refinance out of this sort of renovation loan and into a permanent loan. If the borrower fails to do this, the lender has the right to call the remaining loan balance due in full at the end of the loan term. This kind of loan is generally used by investors because it is quick to access, and more flexible than the conforming products in terms of how the renovation needs to be done and how the borrower's qualifications are measured. The catch is, these loans class have significantly higher interest rates and fees, and much larger down payments required than the conforming products do.

The Good

A renovation loan is a beautiful thing: It allows a home-buyer to not only purchase a loan, but to purchase a fixer-upper and renovate it without needing to secure additional financing. And even better, it allows both home-buyers and homeowners to receive a loan amount based on the future value of the property, post-renovation. In appraising a property for a renovation mortgage, the appraiser estimates the "as-completed" value, or after repair value (ARV) of the property based off construction plans provided by the borrower, and the maximum loan amount is calculated based on this ARV.

There are a great many reasons why renovation mortgages make sense. If a home-buyer is able to purchase the ugly duckling in a neighborhood of nice homes, and renovate it into a gleaming new swan, he or she is adding value to the property - and likely more value than the money being invested in the renovation. Furthermore, going with the ugly duckling may be the only affordable way into that nice neighborhood, especially in our ultra competitive, Bay Area market.

However, renovation mortgages don't restrict home-buyers to single family homes. As long as a property will be owner occupied, both the FHA 203(k) and Fannie Mae HomeStyle allow home-buyers to purchase up to a four unit property. In fact, they allow home-buyers to purchase and renovate a 5 unit and/or mixed use property, as long as when the renovation is done, a maximum of four residential units remain and any commercial space makes up less than 50% of the property's interior space.

I don't believe there's a residential loan product out there today which provides more wealth generating potential than the 203(k) and HomeStyle. In fact, more investors should consider using Fannie Mae's HomeStyle as a way to finance their flip products, as the program is flexible enough to work in many situations, and could save most investors a great deal in financing costs. And as a broker with relationships with over 100 lenders, not only do I know a few, great renovation lenders. I even know of one lender who has a proprietary construction loan that's just like the FHA 203(k) program except that it allows for ground-up construction!

The Bad

While renovation loans come with a host of benefits, they do have their drawbacks. First of all, the fact loan amount with renovation loans are based on construction drawings, means that you need construction drawings prior to getting approved for the loan, so you have to pay for design costs out of pocket. Also, if you're working with a very competent loan officer and HUD approved renovation counselor (which are required for the FHA program and strongly recommended for the HomeStlye program) you should be able to close a loan like this in thirty days or less. However, in our competitive Bay Area markets, this added complexity can make it difficult to use a conforming, renovation loan to purchase some properties that are already on the market, unless the sellers are willing to accept a standard, 30 day close.

Another issue borrowers sometimes have with the 203(k) and HomeStyle programs is the programs require a general contractor (who is also not the borrower) do the renovation. In my opinion though, this requirement is generally a good one, as there are a lot of under-qualified handymen out there who think they're perfectly capable of doing a major renovation, and a general contractor's license provides at least some assurance to borrowers and lenders alike. Likewise, I think the 203(k)'s requirement to hire a HUD approved, renovation counselor to oversee the bidding process, construction progress, and confirm the fairness of the contractor and quality of his or her work, is a great requirement overall. These counselors usually charge, at most, around 1% of the renovation cost, and provide a great deal of extra security to any borrower who isn't a construction expert. Also, their expertise helps keep the loan approval and dispersement process on schedule.

In sum, the downside of renovation loan programs is that these loans and the projects funded by them are complex, and for that reason the loans can take longer to close, and the projects to follow them can be stressful for homeowners and home-buyers. However, for a home-buyer prepared with a team of competent finance, design and construction professionals - especially a home-buyer willing to look off market or at old listings for the right property - a renovation loan is a wonderful way to build wealth at home.

The Ugly

By now I hope you already see that ugly isn't always ugly. Ugly can mean cash flow. Ugly could be your family's ticket into a better neighborhood or school district. To let you in on a secret pass-time of mine, I'm constantly looking around for the ugliest house on the block, and thinking to myself, what would it take to make it as good as or better than all the rest? With the power of a renovation mortgage, ugly can be the beginning of a beautiful new home or business venture.

If you have any questions about renovation mortgages, or anything mortgage or real estate related, please don't hesitate to email me or give me a call.

Anthony Capitan

Mortgage Consultant

C2 Financial Corporation

510.833.5027

cap@anthonycapitan.com

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The services referred to herein are not available to persons located outside the state of California. This licensee is performing acts for which a real estate license is required. C2 Financial Corporation is licensed by the California Bureau of Real Estate, Broker # 01821025; NMLS # 135622. Loan approval is not guaranteed and is subject to lender review of information. All loan approvals are conditional and all conditions must be met by borrower. Loan is only approved when lender has issued approval in writing and is subject to the Lender conditions. Specified rates may not be available for all borrowers. Rate subject to change with market conditions. C2 Financial Corporation is an Equal Opportunity Mortgage Broker/Lender.

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