203K Rehab Loan – Complete List of Benefits
Section 203k rehab loans enable homebuyers and homeowners to finance both the purchase (or refinancing) of a home and the cost of its rehabilitation through a single mortgage or to finance the rehabilitation of their existing home.
When buying a house that needs modernization, homebuyers usually have to follow a complicated and expensive process. The interim acquisition and improvement loans often have high interest rates, short repayment terms and a balloon payment.
Section 203k offers a solution that helps both borrowers and lenders, insuring a single, long term, fixed or adjustable rate loan that covers both the acquisition and rehabilitation of a property.
Section 203k insured loans save borrowers time and money. They also protect the lender by allowing them to have the loan insured even before the condition and value of the property offer adequate security.
The 203k Loan is a great way for new real estate investors to get started. The 203k loan has serious potential and allows you to avoid the competition of investing in already beautiful, finished homes, which command premium pricing. This loan will allow you to build equity without putting a lot of your hard earned cash to work. Wise man once say – “It’s better to leverage other people’s money.” In this case – it’s the lender’s.
At the end of the day, you add value through rehab. And I can assure you, it’s a great way to build equity.
It Must be Owner Occupied
It’s probably the most-used renovation loan in the housing market: FHA 203k. This mortgage loan option helps home buyers purchase and fix up a home with one mortgage, one interest rate, one payment. The caveat to this mortgage is that the house must be your actual home, not an investment home or a second home.
This requirement of the FHA 203k leads people to ask the question “How long do I have to live in a house with FHA 203k?” The FHA typically requires borrowers to occupy the property they’re buying and use it for their primary residence for at least one year.
There’s only one legitimate way to use a 203k loan for an investment property. You can buy and renovate — or construct or convert — a multifamily (2-4 unit) building and live in one of the units.
FHA allows borrowers to purchase 2-, 3-, and 4-unit properties and renovate them using the 203k loan.
To fulfill FHA’s residency condition, you’ll need to occupy one of the units yourself as your primary residence for at least 12 months.
You can rent out the other unit(s), and even use the rental income to cover your monthly mortgage payments.
Here’s the high level: This 203k loan is part of the FHA insured loan program. At it’s core the loan is a two part loan used to do the following: 1. Purchase a property and 2. Rehab a property.
You can buy a property that is in desperate need of a rehabilitation. And this program allows you to roll all these costs into your loan, including any cosmetic and structural investments that may need to be made.
Type of Assistance: Section 203k insures mortgages covering the purchase and rehabilitation of a home that is at least a year old. A portion of the loan proceeds is used to (1) pay the seller, or, if a refinance, to pay off the existing mortgage, and the remaining funds are (2) placed in an escrow account and released as rehabilitation is completed.
The cost of the rehabilitation must be at least $5,000, but the total value of the property must still fall within the FHA mortgage limit for the area. The value of the property is determined by either (1) the value of the property before rehabilitation plus the cost of rehabilitation, or (2) 110 percent of the appraised value of the property after rehabilitation, whichever is less.
You can see the mortgage limits for your area HERE.
Many of the rules and restrictions that make FHA’s basic single family mortgage insurance product convenient for lower income borrowers apply.
Note that lenders may charge some additional fees, such as a supplemental origination fee, fees to cover the preparation of architectural documents and review of the rehabilitation plan, and a higher appraisal fee.
After 12 months, you could rent out the unit that you live in and move on to purchase other real estate.
But FHA is not for serial investors. Once you use one FHA loan, you likely can’t get another one. You’ll have to secure other financing if you move out and buy again.
Also, keep in mind that you will be living side by side with your future tenants for those 12 months — some may consider this a downside while others won’t mind.
Another downside: FHA loans come with pricey mortgage insurance premiums (MIP) which borrowers are normally stuck with until they sell or refinance into a different loan program.
So there’s a lot to consider before going the 203k investment property route.
But for the right borrower, this could be a great strategy to finance and renovate their own home and a few rental units at the same time.
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Example 1. You find a $180,000 duplex that is going to be foreclosed upon. Now normally it may be challenging for a bank to lend on a property that is so distressed. In fact, it may even be impossible for traditional financing. But with the 203k loan, you can make this work.
Purchase Price: $180,000.
Rehab Costs: $20,000
+Paint – $2,500
+Carpet – $2,500
+Cabinets – $5,000
+Other – $10,000
TOTAL – $200,000
There is a 3.5% required down payment minimum. Therefore, math whiz, you will put down $7,000, part of the closing costs, and borrow the rest. Leverage. Use it.
Down payment – $7,000
Closing costs at 2.5% – $5,000
TOTAL DOWN- $12,000
TOTAL Borrowed – $188,000
The units are a 2 bedroom x 1 bath. Commonly referred to as a 2×1.
Reasonable rent is $1,600 for one unit. You will live in the other unit, as aforementioned.
Your mortgage payment including PMI will be ~1,400 with a 30 year fixed at 5.75%.
You will be able to move out after the first 12 months. And, at that point, you can charge $1,600 x 2 = $3,200 for the entire property.
Setting aside 10% a month for repairs, or $320 dollars, you will have the entire property paid off in less than ten years.
But what if you want to get out of the property earlier than ten years?
What if you want to sell at 5 years and make another investment?
Maybe a larger purchase with greater cashflow opportunity the second time around?
Assuming 3% appreciation of the property, per annum, the property would be worth roughly $232,000 at the end of 5 years – an increase in equity of $32,000.
Additionally, at the end of year 5, the outstanding mortgage would be reduced to roughly $86,000. See the benefit of having two renters in a duplex?
Assume closing and selling costs of $12,000, or roughly 5% of the total sale price of $232,000.
The sale of the home would net you roughly $134,000 before taxes. NOT BAD.
203k Approved Contractor
You must use a 203k approved contractor. The FHA will inspect the property, makes sure the work was done correctly, and pays the contractor directly.
How does the contractor get paid? How do the contractors get paid? The contractors are paid in a series of draws by the borrower’s lender through escrowed funds. At closing, the lender places the rehab/improvement funds into an escrow account.
Note that if you have the skills — and your lender’s approval — you could do the repair or renovation work yourself on a property that qualifies for a Section 203k loan from the Federal Housing Administration (FHA). And, if you’d also like to be your own general contractor, you’ll need to be licensed to do the work. Otherwise, it’s important to not only find a contractor, but also work with one who is familiar with the requirements of a 203k project.
If done properly, you will make your cash investment back on the property from cashflow in less than eighteen months.
What’s are some Eligible Activities?
The extent of the rehabilitation covered by Section 203(k) insurance may range from relatively minor (though exceeding $5000 in cost) to virtual reconstruction: a home that has been demolished or will be razed as part of rehabilitation is eligible, for example, provided that the existing foundation system remains in place. Section 203(k) insured loans can finance the rehabilitation of the residential portion of a property that also has non-residential uses; they can also cover the conversion of a property of any size to a one- to four- unit structure. The types of improvements that borrowers may make using Section 203(k) financing include:
- structural alterations and reconstruction
- modernization and improvements to the home’s function
- elimination of health and safety hazards
- changes that improve appearance and eliminate obsolescence
- reconditioning or replacing plumbing; installing a well and/or septic system
- adding or replacing roofing, gutters, and downspouts
- adding or replacing floors and/or floor treatments
- major landscape work and site improvements
- enhancing accessibility for a disabled person
- making energy conservation improvements
HUD requires that properties financed under this program meet certain basic energy efficiency and structural standards.