Renovation loans, step by step

The short version

A renovation loan puts the purchase or refinance of a home and the cost of the work it needs into one loan, with one closing. It's the first mortgage itself, not a second loan alongside it.

The appraiser values the home as it will be when the work is finished. The money for the work is set aside at closing and is generally paid out in stages as the work is done and inspected.

The value it's based on

The loan can count what the home is expected to be worth after the work, not only what it's worth today. On a purchase, it's generally limited by what the home and the work cost, too. On a refinance, how much the value after the work counts depends on the program.

The appraiser values the home as it will be when the work is finished, using the scope of work and the contractor's bid. That's an estimate made before the work starts, not a promise about what the finished home will be worth.

How it works, step by step

The order is roughly this:

• The home. Find the home that needs work, or start with the one you have.
• The contractor and the plan. The contractor writes a detailed bid, and the work is written up as a scope of work. The lender generally reviews the contractor. Plan on a licensed, insured contractor: doing the work yourself is limited, and many lenders don't allow it.
• The consultant, on a standard FHA 203(k). A 203(k) consultant from HUD's roster writes up the work and inspects each stage. On a limited 203(k) a consultant is optional, though a lender may require one. On Fannie Mae HomeStyle Renovation and VA Renovation, the lender arranges the inspections, and some lenders use a renovation consultant too.
• The appraisal. The appraiser values the finished home from the scope of work and the bids.
• The contingency. Budgets generally include a contingency for what turns up once the work starts.
• One closing. The purchase or refinance and the cost of the work close together. The money for the work is held in an account.
• During the work. The money is generally paid out in stages, often called draws, as the work is done and inspected. Some programs can release part of it before the work starts, for things like materials or permits. Changes to the plan once work starts generally need the lender's OK, and permits are pulled where the work needs them.
• When it's finished. There's a final inspection. Contingency money that isn't used generally goes toward the loan balance rather than being paid out.

It generally takes longer to close than a standard purchase, because the bids, the scope of work and the appraisal come first. There's also a deadline for finishing the work. That matters to the seller and the agents too: the contract needs room for the extra time, and the contractor, any consultant and the appraiser need access to the home before closing.

The programs I place

I place FHA 203(k), Fannie Mae HomeStyle Renovation and VA Renovation in Georgia and Florida. Depending on the program and the lender, a renovation loan can be used to buy a home or to refinance one. Which program fits depends on the work, the home and the borrower's situation, and the lender's underwriter makes the decision on the loan.

FHA 203(k) is HUD's Section 203(k) rehabilitation mortgage: an FHA loan, for a home the borrower will live in, that includes the cost of the work. It can be a purchase or a refinance. FHA 203(k) comes in two kinds: a limited version for smaller, non-structural repairs and updates, such as a kitchen, flooring, a roof, or heating and cooling; and a standard version for larger or structural work, such as an addition, foundation repairs or moving a load-bearing wall, which uses a 203(k) consultant from HUD's roster. Which kind fits depends on the work and the lender. HUD sets the limits for each kind, and they're on its page, below.

FHA 203(k) isn't only for first-time buyers, and it isn't only for homes in poor shape.

Fannie Mae HomeStyle Renovation is a conventional loan that includes the cost of the work, for a purchase or a refinance. It follows conventional rules, so borrower-paid mortgage insurance, when there is any, can come off once enough equity is built. It can cover a wider range of improvements than FHA's program: generally anything permanently attached to the home that the appraisal supports. That can make it a fit for buyers or owners going the conventional route, or for work FHA's program doesn't cover.

VA Renovation is a VA-guaranteed loan that includes the cost of repairs or improvements, for a home the borrower will live in, from lenders that offer it. It keeps the usual VA features: there's no monthly mortgage insurance, and there's a one-time funding fee, which is waived for veterans who receive VA compensation for a service-connected disability, among others. What work is allowed varies more by lender than with the other two.

Two common misreadings

A common belief is that if a house needs work, you either pay for the work yourself after you buy it, or you only look at homes that are move-in ready. There's another way: the work can go into the same loan, with one closing, and the loan can count what the home is expected to be worth after the work.

Another is that a renovation loan means the money comes to you and you hire whoever you like. Not quite. You generally pick the contractor, but the lender reviews them, and the money for the work is generally paid out in stages after the work is inspected.

How it differs from building, or from a HELOC

Building new. A construction-to-permanent loan uses much the same machinery, with a budget, inspections and payouts in stages, but it builds a new home from the ground up. A renovation loan works on a house that already stands. For a new build, see the construction-to-permanent lesson.

A HELOC or home-equity loan. Either one usually sits behind the first mortgage, is generally based on the equity the home has today, and leaves the owner in charge of how the money is spent. A renovation loan is the first mortgage itself, can count the value after the work, and generally pays for the work in stages as it's inspected.

A cash-out refinance. It's based on the home's value today, pays the owner the difference once the loan funds, and the lender doesn't oversee a contractor. A renovation loan can count the value after the work, and the money goes to the work.

Questions worth asking early

A few questions that make the process clearer from the start:

• Is the contractor licensed and insured, and will the lender accept them?
• Does the job need a 203(k) consultant, and who arranges one?
• What happens if the bids come in higher, or the appraisal lower, than planned?
• How are inspections and payouts scheduled, and what does the contract say about changes once work starts?
• Can the home be lived in while the work is done?
• In Florida, will an insurer cover the home as it is before the work? An older roof can make that harder. A renovation loan can include roof work, but the home needs homeowners insurance in place at closing, so it's worth talking to the insurance agent early.

From the source

HUD and Fannie Mae explain their programs, and the limits that go with them, on their own sites. VA explains its purchase loans, including improving a home, on its own site:

• HUD: 203(k) rehabilitation mortgage insurance
• Fannie Mae: HomeStyle Renovation mortgage
• VA: purchase loans, to buy, build or improve a home

Words in this lesson