How We Used the 203(K) Rehabilitation Loan to Buy our Home
When we found our house on Zillow, we knew that it was gutted and had no idea what the inside would look like. But more importantly, we did not know how the heck you would go about buying a place like that.
When a house doesn’t have walls, plumbing, or electric, it’s not really a house. It’s more of a big wooden box. And in order to finance the purchase of said box, you cannot do so with conventional loan types. So, this got us thinking about a construction loan. After some googling and researching, we found the 203k Rehab Program that would eventually change our lives (enter: the start of the Renovation Husbands).
The 203k Rehab Program is technically a HUD insurance program which means it's a government-backed mortgage. Essentially, the government agrees to back your loan incase you flop during the rehab process. When going through the process of a home purchase, regardless of loan type, it’s helpful to remember that almost every system is in place to protect the bank.
When we started, we had about a million questions; so hopefully we can pass on what we learned to the next person who will find it helpful.
The first step we'd recommend is to read the FHA website where you can get all kinds of basic information. Then, call your bank and get pre-approved (regardless of loan type you are looking for), so that you have a better idea of what's in your budget.
\\ Disclaimer: We went through this process in 2017 so it's possible that some aspects of the process may be different now. Make sure to do your own research, too.
Our 203K Loan Glossary:
FHA: Federal Housing Administration
Rehab Loan: Helps with buying and renovating a home (FHA 203k Loans are one type)
FHA Loan: A type of home loan that helps make buying a property or doing major renovations, more accessible. Also really helpful for first-time homebuyers. There are several different types of FHA loans.
203K: A specific type of FHA loan
HUD: U.S. Department of Housing and Urban Development who is responsible for assisting in affordable housing
PMI: Private Mortgage Insurance is an additional payment made by the home buyer, until they've reached 20% equity.
1. Why THE 203K Rehab Program
When you find a home that needs a lot of work, or is not habitable, HUD understands a few things:
The average person/family is not able to purchase a home and then pay out of pocket for the necessary repairs.
Taking this initiative can be very expensive (but also financially rewarding when the value of the property increases)
In many cases the house is not habitable for up to 6 months, so the average person cannot pay 2 mortgages or rent payments simultaneously.
In order to alleviate these pain points, this program allows you to finance (take a mortgage) for the acquisition (sticker price) + renovation costs all in one mortgage (one monthly payment).
They also allow you to include four months of mortgage payments into the mortgage principle, which made a huge difference because then we didn’t have to make our first mortgage payment on the 203k loan until 5 months after we closed. In the meantime, we were able to continue paying the rent at our primary residence, while we jump started construction in Boston.
Now under the umbrella of FHA loans, there are two different 203k loan options: Limited, which is a fast track version for somewhat smaller home improvements, like a new roof, and the Standard version, which supports extensive work. We used the Standard loan and while we can't speak to the Limited version, we still recommend starting with the FHA website - it's a great source and also very reader-friendly.
2. The Cost
The total loan amount for the 203k Rehab Program is MUCH more expensive than conventional loans, or even the standard FHA loan on its own. There are several additional fees paid to both the bank and HUD.
For example: we paid $10k JUST FOR TAKING THE LOAN to HUD. We also had to pay a HUD-approved consultant prior to, during, and after construction to verify work requirements and completion.
The nice thing is that while some of these costs are upfront, they can ALL be financed into the mortgage. The initial HUD contractor fee will be credited back to you at closing.
3. The dreadful PMI
We took advantage of an FHA program which came with a huge disadvantage. Because we were only making a 3.5% down payment, we were far from having 20% equity in the property.
Equity is the difference between the value of your home, and your mortgage. The more the property is worth, and the less you owe, the more equity you have.
Remember that the bank’s #1 goal is to protect themselves. When you do not have 20% equity in the property, you are a higher risk to the bank. If you cannot make your mortgage payment, the bank may not be able to sell the property for enough money to cover the purchase price of the home.
This is where the Private Mortgage Insurance, or PMI comes in. The PMI is an insurance payment that is bundled into your mortgage payment. The amount you pay is determined by how much equity you have. The closer to 20% you have, the lower the payment. Our PMI added $400, yes $400, a month to our mortgage payment!
For many banks once you reach 20% equity (with standard mortgage payments or extra principle payments), the PMI is reduced and then removed. I would not trust your bank to do this automatically, so make sure to keep an eye on it, or call your mortgage holder to check in.
Keeping your PMI until you hit 20% equity can take a very long time and would be extremely expensive. However, we hoped that once the work was complete we would increase the value of our home and obtain the 20% equity that way - a refinance was in our future.
4. Choosing a Bank
You will find that only some banks are certified to participate in this program. The bank recommended to us by our realtor was not on the list. I contacted them anyways, and it turned out that they did actually participate - so, it's definitely worth a call if you have your heart set on a bank. It's always important to shop around to review rates and fees of different banks; although I am certain almost no one does this because it’s so much work. Confession: we didn’t, we were exhausted.
More importantly I would inquire about how many of these loans the bank originates. We went to a bank that does quite a few so they were well versed in the process and able to coach us through it.
These loans are COMPLICATED (but don’t worry, you can do it!!)
5. Know your 203k Limitations
FHA loan limits (the amount you are able to borrow) are established based on where the house is located. What’s cool is that you can also use this loan for multi-families and the bank will count potential rent income towards your current income to help you qualify. This is a crazy awesome, no-brainer way to break into real estate investing and also a little crazy scary, too.
The max loan for our county is $598k and boy did we use it all. It is important to emphasize that this is the max loan amount. Our total project exceeded $598k, but we were able to put enough money down, and negotiated with the seller, to drop the financed amount below the limit.
6. Working with a Real Estate Agent
Find an agent who REALLY knows the neighborhood so you can have a better idea of your ARV (After Repair Value). Understanding the potential value of the home AFTER construction, is a really important part of our exit strategy. If your agent has 203k experience, that’s even better.
7. Running Initial Numbers
When we first sat down with the bank (before making an offer or even seeing the house), the mortgage person asked what the cost of renovations would be. We literally looked at each other and shrugged. I piped up and said “$75k?!”. He wrote it down and that became the basis for all of our math.
If I had to do it over, I would have worked backwards.
First, have the bank tell you what your maximum loan that you qualify for, or the max you feel comfortable borrowing.
Cross reference that amount with the max loan amount for the 203k Program in your county.
Subtract the acquisition cost that is due to the seller.
The remainder is how much you can borrow for construction costs.
Had we done this. we would have just requested the max amount we could borrow for construction costs. Best case - your construction costs are less than the max, and you don’t need to borrow as much. You will have several opportunities to re-work the numbers prior to closing.
The reason we would take this approach of max amount is because we underestimated and had to re-calculate the numbers several times. Our construction estimates turned out to be more than $75k and making the loan bigger, is a lot harder than making the loan smaller (think: the reverse of cutting your bangs).
8. Find a House, See It, and RESEARCH
This isn’t necessarily 203k specific, but it’s generally good practice for home buying - do your RESEARCH. The more information you have on the house and the seller, the better you can negotiate. For instance, our Queen Anne had been owned for a bit over a year by the previous seller. Knowing he had put time and money into the house, we had to consider what his costs were. We knew that he was a single male who appeared to be a manager at a car dealership (thank you, Facebook.) Google street view also allowed us to see construction photos and when the roof was replaced. We then dove into public records and found the purchase amount (from the deed) and his final loan amount (from his mortgage information). Turns out he also started with a 203k Loan, funny.
With this information, we could make an educated guess about the least he was willing to sell the house for. We also could see that the taxes were paid and that there weren't any additional liens (mortgages) on the property. All of this helped us feel like we were making an informed decision, and it helped us have a good idea of what we should offer.
If you have a good agent, they will also be able to gather more information from the seller’s agent. For instance, we were able to find out why he was stepping away from the project and some of the offers that he had declined thus far. This information was super helpful. One thing to remember is that if you are with your agent and theirs, let your agent do all of the talking.
9. Find a General Contractor (GC)
I have literally no advice to give you in this category. I would start by asking your trusted realtor and family/friends/Facebook yada yada. We happened to know someone who works as a GC, who wanted to dive into these types of projects on his own. Our GC lined up all of the sub-contractors we would need for the scope of our project (plumber, electrician, insulator, plaster). We all went to the house together for walk throughs and our GC gathered and negotiated quotes. If you see a number and are not sure, ask 1 million questions.
We were really comfortable with our GC, as you should be, and were very transparent about the amount that we are able to borrow within the confines of our loan. He was able to work with us to help us stay within budget.
//Note: An offer being accepted and finding a GC does not need to happen in a specific order. We were lucky to have our offer accepted at the same time that we found a GC, which made the process a bit smoother.
10. HUD Contractor
This part was very confusing to us. The HUD contractor oversees the money set aside (escrowed) in the mortgage for construction, and is assigned once an offer is accepted. The fee is based on the cost of the project. For us the fee was $1k and we paid directly with a personal check. That amount was eventually credited back to us at closing. But, it’s important to know that if you back out of the property, you lose that money - forever.
Our HUD contractor met us and our GC at the house for a walk through where we discussed two things: required home repairs (needs) and wants. Required work is what has to be done to meet FHA standards - things that address safety issues, improve security, and make for sound structural work. For instance, you need walls, but you do not need trim. In our case, we made it clear that we wanted to strictly bring the house to code (along with FHA standards), and the rest of the finish work we would perform later.
The HUD contractor takes all of their notes and writes up an estimate. The cost estimates are broken into categories such as exterior, electric, heat, plumbing, kitchen, etc. and there is a number and letter for each item. The number is the estimate. The letter indicates whether it’s required.
Next, you review the numbers and submit any changes. Once your revisions are complete, it goes to your GC to submit their bids. Meaning, they put in the actual quoted costs, plus their fee on each line item. The amount they enter can be very different than the number entered by HUD. For instance the HUD contractor way under estimated the cost of insulation, but overestimated the cost for a new kitchen. There is a final HUD review to make sure the costs are reasonable.
11. A Few Random Details
You have a 6 month timeline for the renovation process from start to finish. Apparently they are flexible as long as you have any delays clearly documented.
If you are able, you can spend personal money to perform more projects or to upgrade things as you go.
Any remaining funds not used, will be deducted from your principal.
Whatever you borrow for construction costs, the bank adds 10% for unforeseen costs. In our case, the house was gutted and everything is was exposed - so there is a lower chance of unexpected surprises. So, the HUD contractor suggested that a good option would be to buy things like appliances, or even add an extra project. This money is was then accessed differently than the general fund, which I will discuss in section 12.
12. Getting Paid
When you close on the loan, an escrow account is set up to hold all of your construction funds. The tricky part of this game is getting access to those funds as they are not available up front. As the homeowner, you need to be able to front the construction costs as the money is reimbursed to you in phases.
Each time you want to access the money, the HUD contractor needs to come and inspect what has been done. Then, once they see it’s completed, they will write you a check. This also means that it is important to have a conversation with your GC about your ability to front money, or use their line of credit with subcontractors. We worked with ours and created a plan.
When you entered those bids with your GC in section 10 (above) that is what you get paid for the project - period. For example… if your GC entered $15,000 for a new roof and the roof cost $16,000, you only get $15,000. The remainder of the money needs to come from you. BUT the inverse is also true… If the roof costs $14,000 you still get paid all $15,000.
Money can also be distributed partially throughout a project. In the example above, if you needed to access money before the roof was completed (maybe to start the next phase of the renovation), and the HUD contractor determined that the roof was 50% complete, they would disburse 50% of the line item amount.
However, each time the HUD contractor comes to write a check, we have to pay them $350. This means it’ll cost you if you keep calling him back at the halfway point of each project, to get more money back. We had 5 inspections ($1,750) built into our mortgage. If we needed more, we’d pay out of pocket.
The check provided by the HUD contractor is a two party check which means both you and your GC need to sign it before it can be cashed.
What is kinda cool is that your GC does not need to submit any invoices or prove what something costs. The only thing that matters is the previously agreed upon line item cost. This allows you to play with the numbers a bit and add a cash buffer up front. For instance, we decided with our GC to inflate the first few projects by a few thousand dollars. That means that the HUD contractor wrote us a check for more than our costs upfront and gave us more cash for the next phase. That’s how we kept it all moving along.
We also added his fee to every line item, but he agreed he would collect his payment at the end.
//IMPORTANT NOTE: The 10% reserve (noted in section 11) which is mandated by the bank, DOES require receipts. Therefore, the HUD contractor suggested that we take things like kitchen appliances out of the Kitchen line item and buy them using the reserve. We felt safe using up the reserve money because there really wasn’t anything in our kitchen, therefore not a big chance of any costly surprises.
The key takeaways are:
Start with a plan - outline the phases of your project (ex: phase 1 included electric and plumbing for us, since the walls were already open). Review this with your GC.
Inflate first - Work with your GC to bolster those first projects and inflate them by a couple thousand. Then, when you get a bigger check when you’re halfway through phase 1, you can feed it to the next phase of the project to get that going.
It’s basically like real-life Monopoly. You get paid when you pass “go”, aka get approved by the HUD inspector.
As we’re writing this 8 years later, we can honestly say we would use this Rehab loan again (and who knows what our next project is …maybe we will!). Yes, it’s costly, but if you’re ambitious, it’s the best way to build equity in your house. Sometimes those fees, like the check to HUD, can be painful, but it’s just the cost of playing the game. There’s no other way we could’ve bought a house in Boston. And, we got rid of our PMI one year later which allowed us to refinance our mortgage and get a new interest rate. All in all - worth it!
