There are two types of home buyers, those who want to buy an existing home in an established neighborhood or subdivision and someone who wants a brand new home that’s never been lived in before. New construction vs. existing is the typical home buying decision people make and there are pros and cons for both. With a brand new home, you get to pick out various features and help with the design. Even in new areas where the homes might typically look very similar from the outside you can still customize your home to make it uniquely yours.
On the other hand, if you buy in a new development with homes still being built and subdivisions being added, get used to the hammering and construction activity. New construction is often farther away from central living areas making the commute a chore. School quality is not yet known either. New homes with the latest in innovations can also be more expensive compared to a similar sized home in an existing neighborhood.
If you buy an existing home you’re buying in an area that’s been around for a while with a better location and shopping nearby. You can pick a neighborhood based upon the quality of the school system. Or, you can choose a location that provides an easy commute to and from work each day. And, existing homes can be less expensive compared to brand new homes with the latest in amenities.
However, inventory for existing homes may be a problem compared to new developments. Pricing will vary based upon the neighborhood. Older homes have fewer amenities and popular options such as a home office or vaulted ceilings might be hard to find as such features weren’t in demand when they were built.
But really, it’s all about personal preferences as there are advantages to either. However, there is a third choice—renovating an existing home.
Renovation vs. “As Is”
When you buy a new home and the home is yet to be built, your lender will base the value and loan amount as if the home has already been completed. With an existing home, the value is based upon the value as it currently stands, as long as there aren’t any structural issues with the property.
When you obtain a construction loan to build a new home, the bank will review your plans and specifications along with your builder’s cost estimate. Then, the bank sends out an appraiser who will make a valuation of the property on a “to be built” basis, which means the appraiser will base the value on the plans and specifications and compare those costs and final value with similar homes in the area. The construction loan is then delivered to the builder in stages and when the home is finally complete, the bank sends out an inspector one last time to certify the home is ready to occupy.
An existing home doesn’t require all the mechanics of a construction loan. Instead, the lender issues a mortgage based upon the sales price or appraised value as the property exists today. You may want to make some changes later on such as adding another bedroom but the lender won’t place value on any future improvements with a traditional mortgage. In such an instance any major additions or improvements later on must be financed with a home improvement loan, cash or a cash-out refinance. Yet all three options have some drawbacks. A separate home improvement loan will be a second mortgage and have a higher rate compared to first mortgage. Paying cash is fine and there are no interest charges when paying with cash but major renovations cost a lot of money and those are funds that might be reserved for other things such as college or retirement. A cash out refinance is certainly an option but there are closing costs involved in a cash out refinance and borrowers should take out cash during a refinance as a secondary option, not the primary motive. Refinancing can be worthwhile to lower an interest rate, change loan terms or switch from an adjustable rate mortgage. Pulling out cash should be a secondary consideration. If all the homeowners want is extra cash and they currently have a good mortgage a home equity line of credit or home improvement is the better option.
A renovation loan however has the advantages of a loan with the best rates and terms as well as borrowing the needed funds for a renovation or major remodel. The lender will then issue a mortgage to cover the purchase as well as funds needed to make the wanted repairs plus closing costs.
Renovations are used to remodel an existing home in an established neighborhood allowing the buyers to customize and renovate a home to their exact tastes, combining the advantages from a new home and an existing one.
Qualifying for a Renovation Loan
Qualifying for a renovation loan is very much like qualifying for any other conventional mortgage. Lenders do require minimum credit scores and based upon the final loan amount compared to the completed value, the interest rate may change. Renovation loans with less than a 20% equity position along with a credit score in the mid-600s can have a higher fixed rate compared to a transaction with much more equity and a credit score of 740 or higher. Lenders will order a credit score from the three main repositories and discard the highest and lowest score, using the middle as the qualifying score. If there is more than one borrower on the renovation loan application the lender will use the lowest middle score for credit qualifying.
Income will be documented using the two most recent W2 forms from all borrowers on the application as well as the latest pay check stubs covering a 30 day period. If the borrowers are self-employed then two years of income tax returns will be required showing consistent, year over year income as well as a year to date profit and loss statement. Lenders will also require bank statements showing sufficient funds to cover any closing costs should the borrowers not roll closing costs into the new loan.
The lender issuing the renovation loan will also order an appraiser and follow a similar protocol that a bank would follow in the instance of a construction loan. The lender will require a copy of construction plans and specifications along with a construction cost estimate from a licensed contractor. The appraiser will then review the plans and specifications and arrive at a value as if the property had already been completed. Lenders refer to this value as the “As Completed” value.
Renovation Loan Sources
It’s important to recognize a renovation loan isn’t an ordinary mortgage. It’s a combination of a construction loan and a traditional mortgage for an existing property and not all lenders are equipped to approve a renovation loan as well as handle the processes needed during the renovation period. With a traditional mortgage, once the loan is approved and documents signed, the lender moves on to the next mortgage application. With a renovation loan, when the borrowers sign closing papers that’s just a part of the process and the transaction isn’t complete until the lender certifies the property has been completed per the plans and is ready for occupancy or otherwise showing all work has been 100% finished.
Renovation loans are some of the least common and they’re sometimes hard to find and as such borrowers who wish to perform renovations on an existing property they obtain secondary financing for the duration of the project then refinance that loan later, typically rolling the second loan into the existing mortgage for a brand new first mortgage. This obviously means two separate closings and higher rates for the improvements.
There are private lenders who will provide funds to buy and renovate or rehabilitate a property but these loans come at a cost. Sometimes a property is in such poor shape that a traditional bank or lender won’t place a loan on the property under any circumstances but a private lender can. However, private lenders offer interest rates much higher than a regular mortgage. Sometimes these rates can be 14-15%, require a significant down payment and high fees.
But there is a solution for those seeking funds to renovate a home that offers competitive rates and terms without taking out a second mortgage, a line of credit or private lending. Fannie Mae has a unique program called the HomeStyle Renovation Mortgage. This loan provides a convenient and less economical way for borrowings to make repairs and renovations with a one-time-close first lien instead of secondary financing.
The HomeStyle Renovation Mortgage
The HomeStyle renovation mortgage is unique in the industry and allows buyers to buy a home and make repairs and renovations as well as roll in qualified closing costs into the final loan. A loan officer experienced with the HomeStyle renovation mortgage will provide the details of this type of transaction and calculate the maximum amount you may borrow. The maximum loan amount is based upon 50% of the As Completed value and the renovations can be no greater than $150,000. Here in San Diego County, the maximum loan amount is also the Fannie Mae maximum loan limit of $580,750. If the maximum renovation cost is $150,000 that would leave a balance of $430,750 and standard loan balance to final value requirements must also be met.
With a fixed rate loan, available in a 15 or 30-year term, the maximum loan to value is 95% for a primary residence and at 90% if the final loan an adjustable rate mortgage is 90% of the as completed value. These figures are for a single family residence but this program can be used to finance a duplex or a three-four unit property as well with higher down payments. Subordinate financing is also allowable and is used to avoid mortgage insurance on higher loan-to-value transactions.
This program can also be used for an investor property as long as the rental is a single family home. Your loan officer can provide the various down payment and occupancy variations as well as quote a current fixed or adjustable rate.
Calculating a Maximum Loan Amount
A buyer sees a property that is for sale at $300,000. Touring the property with his contractor the buyer considers various renovations that will be made and the contractor will provide a cost estimate. It’s important to note here the contractor must be approved by the lender who will handle the renovation loan. Many times these lenders have a list of contractors already approved and if the buyer wants the lender can have the buyer choose from the lender’s list rather than finding a new contractor and having the contractor go through the approval process.
The contractor lists the requested changes and provides an estimate of $75,000. Since the renovations are less than $150,000 the request can be approved. The $75,000 is comprised of:
Labor and Materials 60,000
Soft Costs (permits, fees) 15,000
Total Purchase/Renovation $375,000
The buyer also wants to finance 80% of the as completed value. The lender orders the appraisal and confirms the value will be $400,000 once the renovations have been completed. The lender uses the lower of the as completed value or the total purchase/renovation cost and in this example that amount is $375,000. 80% of that amount is $300,000 which is the final loan amount. The shortfall of $75,000 will have to be provided from the buyer’s own funds or a combination of a down payment from the buyer and a second lien for the balance to keep the mortgage at 80% of the value of the home.
This also works for a refinance on an existing mortgage and instead of making an offer and providing a sales contract, the lender simply orders an appraisal to be based upon the appraised value of the home as it will be completed. The process to be approved for a renovation loan on a property the borrower already owns is essentially the same as for a purchase but without a sales contract.
During the Renovation
Using the same example as above, let’s use the total of the labor, materials and soft costs of $75,000. If you’ve never obtained a regular construction loan you may not be familiar with how the contractor is paid during the construction but what the construction lender doesn’t do is hand over the entire amount of the construction costs to the builder in one lump sum. The reason is obvious but instead the funds are doled out in stages.
The lender is required to deposit the $75,000 with a third party during the renovation process and is required to manage these funds and distributed as the work is completed. The lender will produce a form called the HomeStyle Completion Certificate which validates all work included in the renovation costs and listed in the plans has been completed 100%. The renovation must be completed within six months and the renovations must be permanent. For example, a lamp might be a nice addition but a lamp isn’t permanently attached to the property. Paint and flooring is eligible because you can’t take it with you when you move. An outside deck, patio or additional bedroom would work because again it’s a permanent improvement.
Sometimes the renovations are so extensive the owners cannot live in the property while the work is being completed. When this is the instance, there can be a payment reserve of up to six months of the mortgage payment which includes principal and interest, property taxes and insurance. This fund can be rolled into the loan amount and is used to make the monthly payments on the mortgage while the owners live elsewhere.
And anyone who has ever been involved in a home remodel, especially a major renovation can tell you, no matter how hard you look there can always be a surprise here and there that needs attention. Perhaps the supports in one of the walls need to be replaced yet during the initial inspection they were unseen. Any such surprises can be addressed with an optional contingency reserve of 10% of the renovation costs for such changes during renovation. If the property is a 2-4 unit, the contingency reserve is a requirement, not an option.
Can you avoid paying a contractor and perform the work yourself? Sometimes lenders allow this but it is very rare. When the owner is approved to perform their own work they’re typically a licensed contractor or the work being done is minor compared to a major renovation. This financing cannot exceed 10% of the as completed value and does not apply to actual labor performed by the owner (sweat equity). Any work that costs more than $5,000 in materials and fees will require a lender inspection.
Renovation Loan Closing Costs
Closing costs can be rolled into the final loan amount subject to the limitations of either the loan-to-value or $150,000 maximum limit. What closing costs can you expect? Your loan officer will provide you with a cost estimate any time at your request as well as provide you with your final potential loan amount and estimated value. Typical closing costs you might see are:
- Appraisal Fees
- Periodic Inspection
- Initial Inspection
- Architectural Fees
- Engineering Costs
- Renovation Draw Fees
These are closing costs that will typically accompany a renovation loan, just as if the transaction were for a new construction loan. In addition to these renovation charges, you can also expect to see:
- Credit Report Fee
- Title Insurance/Review
- Loan Document Fee
- Loan Processing Fee
- Settlement/Escrow Fee
- Tax Service
- Flood Certificate
Renovation Loans and Real Estate Investors
Real estate investors love this loan but unfortunately this project isn’t used very often when it should be. Real estate investors find distressed properties then determine whether or not certain improvements and renovations would inflate the value of the property to the point where the property can be quickly sold for a profit or can be used for a long term hold and used for cash flow. Real estate investors typically use bank financing for a short term construction loan then at the end of the construction period pay off the construction loan either refinancing into a permanent mortgage or sell the property and pay off the loan with the loan proceeds.
Renovation loans for these non-owner occupied properties are only for single family residences and require at least at most an 85% loan based upon as completed value when financing with a fixed rate mortgage and 75% for an adjustable rate loan.
The Fannie Mae HomeStyle renovation loan has been around for years but has not been given the sort of promotion it deserves. However, once this program begins gaining traction it should be the financing tool of choice when buying an existing home and renovating it or refinancing an existing mortgage and making permanent improvements to the property that increase the overall as completed appraised value. Some home owners who are thinking of selling and moving to an updated home might find out they’d rather refinance into a Fannie Mae HomeStyle Renovation loan instead, bringing the home up to date and increasing the value of the property.
We’ve tried to cover as much as possible in this article but we know you’ll have more questions than we can answer here. If this sounds like it might work for you, all it takes is a brief, no-obligation telephone call or an email. Why sell and move when you can upgrade your current home?
Thank you Chad and Team
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