What You Need to Know before Financing a Rehab Home
Rehab homes are a great choice for someone with the energy and skills to transform a dilapidated structure into comfortable living space. If you’ve got your heart set on buying a fixer-upper, you probably already know that the road ahead will be a little tricky. Whether you’ve taken on the project because you like a challenge, want to make a profit, or didn’t have the money to buy a finished home, understanding and preparing for the challenges you are about to face will reduce your stress and remove hurdles to success over the coming months.
Budget for the unexpected
It is not always easy to foresee what you will find when you begin opening up walls, ceilings, and floors. Your contractor should be able to give you a good idea of the overall price of the project, but it is wise to manage your own expectations by adding another 5-10% on top of that for the unknown. The project won’t necessarily cost you more but there is no harm in setting yourself up for relief and joy rather than dismay and an empty bank account.
Here are some steps you can take to improve the likelihood that you can afford the project from beginning to end.
- Add up all of the rehab costs (materials and labor for all contractors).
- Add up the mortgage closing costs, taxes, insurance, interest, and other fees.
- Subtract all costs from the home’s estimated post-rehab market value.
- Subtract another 5 to 10 percent of the home’s value to account for unforeseen issues.
Don’t go it alone – hire a licensed professional
Despite what you see on reality television, flipping houses is neither easy nor speedy. It is a tough job that requires the skills of one or more professionals. The work is complicated and often dangerous, requiring years of learning and experience.
Your mortgage originator will only sign off on financing for a project that is overseen by a licensed contractor. Non-professional services produce unprofessional and potentially unsafe results that your mortgage originator will not want to take a chance on. Therefore, you will need to provide proof that you are working with a licensed contractor before you can sign the loan papers.
Note: Though you will need to hire a contractor to accomplish the lion’s share of the work, you can be involved in the project if you would like, however you will need to talk to your mortgage originator to differentiate between projects your contractor must be responsible for and projects you can handle yourself.
Expect a larger down payment and an adjustable rate mortgage
Rehab projects are similar to construction projects and put your lender at a similar level of risk because they are not fully secured. In other words, while the work is in progress, the amount of money invested by the lender may exceed the value of the property. The way mortgage lenders can get around this on a rehab is by requesting a higher down payment—usually 20 percent of the home’s purchase price.
You can expect your lender to offer you an adjustable-rate mortgage (ARM) until the work is done. While the interest rate of an ARM fluctuates with the market, you can usually find a product where the loan rate and payment remain the same for five, or even seven, years. Once the work is completed (rendering the loan fully secured), you should be able to refinance the loan into a fixed-rate product. You may be able to find other options, including limited fixed-rate rehab mortgages, so check with your lender to find out what solutions they can offer.
If you can’t afford the 20 percent down payment, you may opt to take out a 203(k) rehab mortgage loan through the Federal Housing Authority (FHA). Before taking this option, you should review the overall costs associated with the 203(k) loan. You may be able to find other options, including limited fixed-rate rehab mortgages, so check with your lender to find out what solutions they can offer.
Talk to your mortgage originator
With all of the above in mind, a great place to start is with your mortgage originator. Mortgages are complicated and, as you are now aware, a rehab mortgage is more complicated than most. You can glean a lot from your reading online but keep in mind that every rehab is different and every mortgage originator and underwriter will look at your rehab project in a different way. Begin a conversation about the home and find out what your specific situation calls for early on so that there are fewer surprises along the way (expecting no surprises during a rehab project may be too tall an order).
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