I have gotten a handful of questions recently about Renovations Loans, and more specifically — What is a 203k Loan? Like many, I knew only that 203ks were “Renovation Loans,” but not much else. So I figured it was time to give it a little look.
- What are they?
- What are the stipulations?
- Where would I go to get my hands on the dough?
- What are the pros, and the cons?
- Are there alternatives available?
History and Use
To start I went right to the source – The Department of Housing and Urban Development (HUD). The Federal Housing Administration (FHA), which is part of HUD, administers various single family mortgage insurance programs. One of which is the 203(k) Renovation Loan program.
In 1978, Section 203(k) amended the National Housing Act (NHA). The objective of the revision was to enable HUD to promote and facilitate the restoration and preservation of the Nation’s existing housing stock.
What makes 203(k) different?
It is unlike most financing, where a lender will not usually close a loan unless the condition and value of the property provide adequate loan security. When rehabilitation is involved, this means a lender typically requires the improvements to be finished before they issue a long-term mortgage.
In a traditional set up, in other words, we are talking two loans: one for the dwelling and one for the rehab. In this case, the rehabilitation loan typically carries a high interest rate over a shortened period. While usually coming in with a slightly higher interest rate (by a ¼ to ½ percent), the 203k loan offers instead a neat little package. It offers one mortgage for both acquisition and renovation. It is based on the projected value of a home when work is complete AND it includes the cost to complete.
To minimize the risk to mortgage lenders, the mortgage loan (no more 110% of projected value) is eligible for endorsement by HUD. As soon as the mortgage proceeds are disbursed and a rehabilitation escrow account is established, the lender has a fully-insured mortgage loan.
Values are based on appraisals. Depending on the complexity of the project and the scope of work, appraisers submit sometimes multiple appraisals on a given property. The most common appraisals are termed “As-Is” and “After-Improved.”
Property eligibility is limited to existing 1 to 4 unit single-family homes. But includes razed homes providing that part of the original foundation remains. Funds may also be used for individual condo units providing that the unit has been approved by the FHA. New homeowners who pay cash for a property may refinance into a 203(k) within 6 months of purchase.
Improvements aka Doing the Rehab
What improvements and items are eligible? All health, safety and energy conservation items must be addressed prior to completing general home improvements.
Technically, luxury items are not eligible. However, the homeowner can use funds to finance such items as painting, room additions, decks, etc. even if the home does not need any other improvements. To sum up, 203k consultant, Paul Lesieur says, “Luxury items are allowed on a full 203k if all the minimum standards have been met and the borrowers qualify.” (More on Minimum Standards in a minute.)
“Luxury” in this case may only be a matter of semantics. Brent Kluge @ 203K World defines luxury items as, “swimming pools, exterior hot tubs, saunas, spas, tennis courts, and barbecue pits.” That paints a better picture, and I guess, in general, “extravagant” might be a better word here.
Some improvements are required.
Required Improvements include the addition of smoke detectors. Plus, improvements must comply with HUDs Minimum Property Standards as well as address Cost Effective Energy Conservation Standards. In practice, energy standards include weatherstripping, caulking, insulating and providing adequate ventilation in both the attic and the basement/crawl space of the home.
As a matter of form “cost of rehabilitation” is defined as (and quoted directly from HUD‘s site):
Cost of Rehabilitation. Expenses eligible to be included in the cost of rehabilitation are materials, labor, contingency reserve, overhead and construction profit, up to six (6) months of mortgage payments, plus expenses related to the rehabilitation such as permits, fees, inspection fees by a qualified home inspector, licenses and consultant and/or architectural/engineering fees. The cost of rehabilitation may also include the supplemental origination fee which the mortgagor is permitted to pay when the mortgage involves insurance of advances, and the discounts which the mortgagor will pay on that portion of the mortgage proceeds allocated to the rehabilitation.
Note: A homeowner may do any or all rehab work themselves.
Sounds Good! Where do I Sign Up?
If you are interested in getting a 203(k) insured mortgage loan, HUD suggest getting in touch with an FHA-approved lender OR a “Homeownership Office” in your area. HUD offers a list of approved lenders.
(More on finding a lender below.)
But Wait! The Process of Applying and Using Funds
HUD provides this list, which outlines the acquisition/application/rehabilitation process:
* Homebuyer Locates the Property.
* Preliminary Feasibility Analysis.
Typically done with a real estate agent. Aka a CMA – Comparative Market Analysis.
* Executed Sales Contract.
A provision included in the sales contract states that the buyer applied for Section 203(k) financing, and that the contract is contingent upon loan approval and buyer’s acceptance of additional required improvements as determined by HUD or the lender.
* Homebuyer Selects Mortgage Lender.
For help finding an approved lender, you may contact your appropriate HUD Field Office. I find mine here. (Simply replace “MD” with your state’s postal code.)
(Note: Consultants Fees can be wrapped into the loan.) The homebuyer provides the lender with the appropriate architectural exhibits, clearly showing the scope of work.
The following list of exhibits are recommended, but may be modified by the local HUD Field Office as required:
A) A Plot Plan of the Site
B) Proposed Interior Plan of the Dwelling
C) Work Write-up and Cost Estimate.
In this aspect, HUD suggests turning to an architect and/or an approved fee-consultant to fulfill this portion of the proposal.
Cost estimates must include labor and materials sufficient to complete the work by a contractor. Homebuyers doing their own work cannot eliminate the cost estimate for labor, because if they cannot complete the work there must be sufficient money in the escrow account to get a subcontractor to do the work.
To find a Fee Consultant (may also serve as inspector in the renovation stages below), you could simply search here — https://entp.hud.gov/idapp/html/f17cnsltdata.cfm.
Kluge from 203K World has advice here: “It is often best to go with a solid recommendation from your lender,” he says. “The Lender must approve of the Consultant for the loan anyway, so this makes the most sense. In addition, it is probably best to find a 203K consultant who is also a licensed Home Inspector. This saves the buyer money in the long run!”
* Lender Requests HUD Case Number.
* Fee Consultant Visits Property.
The consultant who prepares the work write-up and cost estimate (or an architect, engineering or home inspection service) needs to inspect the property to assure: (1) there are no rodents, dry rot, termites and other infestation; (2) there are no defects that will affect the health and safety of the occupants; (3) the adequacy of the existing structural, heating, plumbing, electrical and roofing systems; and (4) the upgrading of thermal protection (where necessary).
* Appraiser Performs the Appraisal.
* Lender Reviews the Application.
* Issuance of Conditional Commitment/Statement of Appraised Value.
* Lender Prepares Firm Commitment Application.
* Mortgage Loan Closing.
* Mortgage Insurance Endorsement.
* Rehabilitation Construction Begins.
At loan closing, the mortgage proceeds will be disbursed to pay off the seller of the existing property. The Rehabilitation Escrow Account is also established. Construction begins. The homeowner has up to six (6) months to complete the work depending on the extent of work to be completed. (Lenders may require less than six months.)
* Releases from Rehabilitation Escrow Account.
As construction progresses, funds release after the work is inspected by a HUD-approved inspector. A maximum of four draw inspections plus a final inspection are allowed. The inspector reviews the Draw Request (form HUD-9746-A) prepared by the borrower and contractor.
HUD provides this page for help with selecting an inspector >> http://portal.hud.gov/hudportal/HUD?src=/program_offices/housing/sfh/insp/inspfaq.
* Completion of Work/Final Inspection.
When all work is complete according to the approved architectural exhibits and change orders, the borrower provides a letter indicating that all work is satisfactorily complete and ready for final inspection. If the HUD-approved inspector agrees, the final draw is released, minus a required 10 percent holdback. If there is unused contingency funds or mortgage payment reserves in the Account, the lender applies the funds to prepay the mortgage principal.
That’s 203k. Are There Alternatives?
Not quite an alternative to 203k, but also offering loans on a “As Completed” value, Lesieur suggests investigating the HomePath Renovation Loan package from Fannie Mae. While primarily meant for REO (Real Estate Owned) homes in foreclosure, this loan is a great option. The caveats here, according to Kluge: “Higher loan rates are higher and renovation allowances capped at $35,000.”
Kluge from 203K World points to Fannie Mae‘s HomeStyle loan as yet another option, though it is a conventional loan. Kluge finishes by saying, “Each ‘Renovation Loan’ has it’s positives and negatives. It is important to not just JUMP at a 203k or another product, but find an experienced lender who can assess your specific needs, understand your project and then recommend a loan which best suits both. It is important to vet your lender just like you would a contractor or agent.”
Thanks out to old friend and sometimes Building Moxie contributor Paul Lesieur for his input in this article. His site: 203k Loan MN (Minnesota).
Thanks out to even older friend and one time class/teammate Brent Kluge.