It’s a dilemma for many home buyers: is it best to buy a turnkey property that maxes out the home buying budget, or is it better to buy a fixer-upper, knowing that renovations often spiral out of control, possibly beyond what the lender will finance?
With a 203(k) mortgage, it’s possible to do both.
How it works
The 203(k) mortgage is officially known as the Federal Housing Administration’s 203(k) Rehabilitation Mortgage Insurance Program. A 203(k) mortgage is a type of rehab loan that allows homeowners to roll the costs of renovations into their mortgage. The loan is insured by the Federal Housing Authority (FHA), so it’s a low-risk product for lenders and, as with other FHA loans, borrowers only have to come up with a 3.5 per cent down payment. Given those parameters, it’s fairly easy for borrowers to qualify, even with less-than-perfect credit history.
There are two options to this product: The Limited 203(k) Mortgage allows homebuyers and homeowners to finance up to $35,000 into their mortgage to repair, improve, or upgrade their home. The other option is a Standard 203(k) Mortgage, which deals with projects that are more than $35,000. With a 203(k) Standard, a HUD Consultant becomes involved and works with both the borrower and the contractor to review the overall the scope of the project and check in at certain points throughout the process to make sure everything is going to plan and request draws from the funds in escrow when the contractor needs them.
Although the 203(k) loan has traditionally been viewed more strictly as a rehab loan and used to move unsold inventory, today it’s used for that as well as purely cosmetic renovations. The project could be as small as getting new appliances to adding a level to the home to mold remediation and repairing other existing damage.
For borrowers, they only have to deal with one loan, one payment, one interest rate, and they get the house of their dreams.
What’s the catch?
There aren’t too many drawbacks to the 203(k) loan, but one is that it may be more expensive initially than a more straightforward loan because it has a slightly higher interest rate. Although it will vary based on the application of the individual borrower, the difference in interest rates could be as low as .25 per cent. Carl Markman, director of national sales for REMN Wholesale, doesn’t think this should be a deterrent for borrowers.
“In most cases, once the work is completed, the borrowers can actually refinance to a little bit lower of an interest rate, and in many cases, get rid of the mortgage insurance that was on the loan,” he explains. “In a lot of cases, if you’re fixing up a home, typically the value has increased. So when people do these 203(k)s/HomeStyle renovation loans, the houses are typically worth more now, so they have built in equity immediately.”
The 203(k) loan is also restricted in that it’s limited to owner-occupied properties; investors seeking mortgages for renovations might do better with a conventional program, the Fannie Mae HomeStyle loan, which is similar but not an FHA loan.
The 203(k) loan isn’t nearly as popular as it should be, given its convenience and the renovation boom that’s been sweeping the country for the past several years. Part of that is because of misconceptions about the loan that are held by both borrowers and industry professionals, as well as a lack of awareness about the loan itself. Some of these misconceptions center around the length of time it takes to close the loan, as well as the extra legwork that goes into the application before the loan can close.
But for people who know what they’re doing, this really isn’t true.
“It’s not like that these days, especially because there are lenders that do this all the time now so it’s almost second nature,” Markman says.
Borrowers have to get bids from contractors and choose one as well as find an appraiser to review the plans and take the future value of your home into account. It may be a couple extra weeks of work, depending on the parties involved, and it may be a bit more difficult to find a contractor who is willing to work with the 203(k) process and wait for their draws, but Brandao says that shouldn’t stop people from taking advantage of a “phenomenal” product.
“We’ve seen people shy away from this because they think that they’re gonna have these horror stories or they think it’s going to take months and months to close a loan,” she says. “That’s not what we see. We see these loans take no longer than any other loan. It’s really just communication and setting proper expectations.”
The key is education, and both Markman and Brandao have found ways to demystify this loan to their clients. REMN Wholesale, a division of HomeBridge Financial Services, Inc., has a renovation specialist on the team who teaches loan officers and realtors the right way to do 203(k)s so that way there’s guidance along the way to make the process easy. “I think it’s really important that if someone doesn’t do these every day, that they can pick up the phone and say, ’What am I supposed to do?’” Markman says. He recently had two 203k loans that were closed within 11 business days. “A few years ago, that was unheard of.”
Similarly, AFR developed a renovation team comprised of people who have previously worked in construction, and this team works with both the borrower and contractor before the loan ever closes. AFR also hosts webinars every month to train clients on how to properly originate 203(k) loans.
The future of the 203(k)
Markman says that the volume of these loans has certainly risen, although not nearly as much as you’d think because professionals don’t know much about the product. In saying that, however, he says that he’s contacted by brokers and bankers on a weekly basis wanting to know more about the 203(k) loan. “It’s definitely on the minds of people because they don’t have the cash to actually do the work on their own.”
And while he says the loan isn’t as difficult as people might think it is, it all depends on the team of people around the loan itself and how well-versed they are on the product.
“People need to be educated so they need to connect with a realtor who knows about renovation loans and a loan officer, and also a lender. I can’t tell you how many times consumers go to one bank and they end up here because the bank, the lender doesn’t do these all the time.” The process doesn’t stop when the loan closes, he says, so you have to have a post-closing department that ensures that the checks go out on time, the borrower’s protected, and the process goes smoothly. “If that happens, it’s a great, great product.”
Brandao agrees that 203(k) loans are still a largely untapped resource.
“Although [interest] has increased – and we’ve seen month over month increases just in our own generation – but it’s still not as prevalent as you would expect. I still see a huge growth potential in the marketplace,” Brandao says. “The interest rates were so low for a long time, people would just refinance and do their home improvements. But now it’s a little different. Now, people want to do it maybe when they purchase the home so that that way, they do it in one shot and they have one interest rate and they’re not having to refinance later in order to be able to get home improvement money.”
If interest rates continue to rise as expected, people may be less likely to simply refinance in order to get money for their home improvements; they may increasingly want to do them when they purchase the home so that they won’t have to deal with refinancing later down the road. And once people discover that the 203(k) is one way to do that, the sky’s the limit for them, and for business.
“My greatest advice would be to become an expert. Know the product, get your network together – meaning that if you do have referral partners, such as real estate agents or whatever your referrals would be to obtain your business, have your network educated on these loans,” Brandao says. “There’s no reason why you can’t close them on time, the same as any other loan, and really be able to expand your product base and your ability to generate business.”
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