As I speak to Chicago area home owners I realize most don’t know the potential of replacing the current mortgage(s) with a new one that is an FHA 203K or Fannie Mae Homestyle rehab loan to add on to a home. In fact most homeowners don’t know there is a refinance renovation loan option at all for their existing home. Many assume they must take out a second mortgage like a home equity line of credit or a true construction loan, often at unfavorable terms perhaps.
What I want to address here is how it can be possible to use an FHA 203k or Fannie Mae Homestyle refinance loan to increase the size of a current home or finance remodeling and updating a home. It may be that the current home is in a desired school district or mature community offering amenities that may not be available by purchasing a brand new home farther out in a newer community. Or the home owners may not feel they have enough equity to trade up to a newer home. Often in a renovation new value or equity may be created by increasing the size of the home or updating it.
Both of these loans can be used to change the look, size, mechanicals and style of a home. The home doesn’t even have to be in need of work or be damaged in any way. These loans also can be used to repair and replace damaged or non-functional fixtures or mechanicals. The best way to present this is by siting an example. Below I will give a hypothetical example of how to use FHA 203K or Fannie Mae Homestyle on your own home. These loans are also a good choice if a home is owned free & clear of any mortgage to finance renovation.
- Let’s say a family has a 2 bedroom & 1 bath home purchased some years ago. Over that time 2 children have come along and the house no longer meets the needs of the 4 family members. The home has a $200,000 mortgage balance on it currently from when it was purchased. The first decision to make would be what sort of renovation is needed and then a budget for that amount of work. Once that is determined I would work with the home owners to compare FHA 203K with Homestyle to see what each offers the home owners and which is a better fit. In this example the homeowners want to add on one or two bedrooms and two full bathrooms. Perhaps there is room to expand the house on the back or perhaps the best way is to add a second floor or expand an existing attic space. In looking at numbers the family has estimates back from a couple contractors showing it should cost about $125,000 to add two new bedrooms and two new baths along with a second furnace and hot water tank. They also plan to move the laundry room to the new area and a few simple updates downstairs like a new front door, paint etc.
In looking at the numbers what would be done is use a new renovation loan to both pay off the current mortgage of $200,000 and borrow enough beyond that to finance the $125,000 in remodeling and expansion costs. The total of the new base loan should be $325,000 then or the sum of paying off the current loan plus the remodeling costs. We will assume any closing costs are paid by the lender so we have an even number of $325,000 for the new base loan in this example.
What I would do is consider what the future value of the expanded home might be based on input from the homeowner about similar sized homes in their area initially just to check initially they are not “over improving”. The mechanics of either the 203K or the Homestyle loan each require an Appraiser to review the final detailed contractor proposal or bid identifying all work and costs involved and use that to appraise the house to its future or “as completed” value. This insures the house will be valued more than $325,000 in this example. Let’s say the newly expanded 4 bedroom, 3 bath home will be valued at $390,000 when fully complete. This is just a hypothetical example but it would not be unheard of for equity to be created beyond the actual cost of the work when a home is expanded from 2 bedrooms 1 bath to 4 bedrooms 3 baths. That is specific to each local market.
Now with such a complex renovation it may well be the home will not be able to be occupied for let’s say 4 months of construction. The family can perhaps live with relatives during these months or may have to rent another place to live at some monthly cost. Both FHA 203K and Homestyle offer the option of borrowing additional funds to pay the mortgage payment principal & interest, property tax, insurance and any mortgage insurance costs due each month once the loan closes while it is uninhabitable. Meaning that the loan may be able to grow by the cost of 4 months of the above monthly costs if the family cannot front the cost of both living elsewhere during renovation and the first months of the new housing payment due during renovation. Most borrowers do not know this is an option with either 203K or Homestyle. In this example let’s assume the family will live rent free with relatives so has no need to borrow additional funds to pay the housing payment during 4 months of construction.
One other aspect of either renovation refinance loan is the Contingency Reserve most home owners would not know about that I educate them on. Either 203K or Homestyle does require a kind of emergency reserve fund amount just in case of something being discovered during renovation this is unforeseen at the start but will cost additional funds over budget and must be repaired. This amount is set equal to at least 10% of the base budget loan amount and as high as 20% in some cases. The rule is that if utilities are all working (electricity, water, gas) the reserve is at least 10%. If one of them is not on then the reserve is 15% reflecting greater chance of an unforeseen issue once utility service is reconnected. In a refinance example as this one is we assume all utilities are working so a 10% reserve is required off the base loan renovation amount of $125,000 or $12,500 in this case.
Finally the refinance renovation loan will be equal to:
- Existing mortgage(s) pay off of $200,000
- Base renovation budget of $125,000
- 10% Reserve of $12,500 of the base budget
The total new 203K or Homestyle refinance loan is $337,500.
What I would do next is review FHA 203K and Homestyle regulations to see which best fits the home owners. Given the home in this example will have a final mortgage of $337,500 from above and be worth $390,000 when fully completed that is equal to 86.5% of value. (337,500/390,000 = 86.5%)
I would consider details like credit score, income etc. as in any mortgage loan to learn what with Homestyle the private mortgage insurance (PMI) cost would be monthly or paid in one single lump sum premium would be in this example. I would also consider those factors to learn what the FHA 203K monthly cost would be and present the options to the home owners for each and the monthly payment for each. Another factor is each type of loan his limits on the size of the loan that in the case of FHA are set by County and in Homestyle are set by state or nationally. Note that each loan requires a version of private mortgage insurance (PMI) given that for Homestyle the home will be mortgaged over 80% of value triggering private mortgage insurance (PMI) and for FHA 203k monthly mortgage insurance is always paid regardless of loan amount or value.
I hope this post has been helpful and encouraging to those that may have thought a Renovation project was too complex or beyond their ability to manage. My intent is always to inform, educate, and generate discussion. Please call me or email me directly or visit my website for more information on renovation loans. I welcome your comments and questions!