What Is a Rehab Loan and How Does It Work?

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Rehab loans are one way to pay for renovations. Learn what a rehab loan is, how it’s different from other loans and how to apply.

What is a rehab loan? It’s a type of loan that can be used to pay for a mortgage and any renovations in one loan. One of the most popular rehab loans is the FHA 203(k) loan, available in two options. Keep reading to learn more about how rehab loans work.

Home rehab loans: What are they?

A rehab loan is a form of financing that allows a borrower to fund both the renovation and purchase of a home for sale using a single loan. A rehab loan can also be used to refinance and make improvements to your current home.

The FHA 203(k) loan is backed by the government and is one of the most commonly used rehab loans available.

Instead of applying for multiple loans, homebuyers can use a rehab loan to buy or refinance their primary residence and refurbish it with only one loan.

“Rehab loans take the financial guesswork out of upgrading a home. They allow the buyer to incorporate the cost of upgrades into the purchase or refinance of the house,” said Lyle Solomon, the principal attorney at Oak View Law Group in Rocklin, California.

The FHA 203(k) makes upgrading, financing or refinancing property easier for home buyers and homeowners.

“Often, renovation loans or some other means of financing desired repairs or improvements can save a borrower thousands of dollars. There is only one closing with one set of closing costs, and equity is created through the transaction,” said Dennis DeGrave, the branch manager for Inlanta Mortgage in Pewaukee, Wisconsin.

What can you use a rehab loan for?

An FHA 203(k) loan can be used for many purposes, including purchasing a residence that requires significant repairs and improvements, buying an outmoded residence that you want to upgrade or fixing up your current home.

There are two different types of FHA 203(k) rehab loans, each with its own allowable uses:

The standard 203(k)

The standard 203(k) is ideal for bigger home improvement projects that will cost at least $5,000. The standard option will cover structural changes; foundation damage ; HVAC, plumbing and electrical upgrades; roofing work; accessibility upgrades; storm shelters; sewage and septic work; landscaping; converting single-family homes to multi-unit properties; and site relocation. Your projects will need to be reviewed by a HUD-approved consultant, and your property will require an inspection following all renovations.

The limited 203(k)

The limited version caps home repairs at $35,000 or less. Covered projects include minor remodeling; replacing appliances; painting; repairs or replacements to plumbing, electrical or HVAC systems; roof, downspout and gutter work; lead paint removal; basement finishing/waterproofing; and more. This limited option might be best after inspection and if repair costs are less than $15,000.

With either option, you can choose between fixed and variable interest rates. You may also be able to select the repayment plan’s terms and duration. “Be aware that, with the limited option, you must stay in the house during the renovation or return within 60 days of completing the project,” said Solomon.

Qualifying for a 203(k) rehab loan

To be eligible for an FHA 203(k) loan, you must meet certain credit requirements, which vary from lender to lender.

“You should have a credit score of at least 580. Some lenders prefer a 620 to 640 credit score,” Solomon said. “Additionally, you must also put down at least 3.5% based on the purchase price plus repair costs.”

If you have lower than a 580 credit score, you may need to put down at least 10%.

You also need to demonstrate sufficient income to repay the loan. That means your debt-to-income ratio (DTI) should be within acceptable limits: Your front-end DTI should not surpass 31%, and your back-end DTI should not exceed 43%.

What’s more, the property being financed must be your primary residence. Plus, the lender has to be FHA-approved and the repair/rehab work must be performed by a contractor, not you.

How to apply for a rehab loan

The FHA doesn’t offer rehab loans itself. You need to shop around for an FHA-approved lender that offers a 203(k) loan.

“A trustworthy bank or local mortgage lender may be able to provide you with this rehab loan,” Solomon said. However, not all lenders offer FHA 203(k) loans.

According to Solomon, here are the likely steps for getting and using a rehab loan :

  • Apply for a rehab loan with a participating lender.
  • Get approved for the loan.
  • Request bids from experienced contractors.
  • Select your contractor.
  • Close on the loan.
  • Have the repairs and renovations completed.
  • Have the rehabbed home inspected, if required.

203(k) rehab loans vs. other types of rehab loans

An FHA 203(k) loan has its pros and cons. On the plus side, you can fund a home purchase or refinance and repairs/improvements in one simple loan, with only one closing involved. You can choose from a fixed rate or variable rate. This loan generally also has lower requirements for the down payment and minimum credit score compared to other types of rehab financing, and the interest rates are competitive.

On the downside, you’ll be required to pay an upfront mortgage insurance premium as well as a monthly mortgage insurance premium with this loan. Depending on your project and whether you choose a standard or limited option, a 203(k) may obligate you to work with a HUD-approved consultant. You are also not allowed to use a 203(K) loan for investment properties.

Below, compare the 203(k) loan to alternative forms of refinancing.

Fannie Mae Homestyle renovation loan

This loan offers either a fixed or adjustable rate, but restrictions apply, including the inability to cover a foundation reconstruction or complete teardown. “This loan may sometimes be a better alternative due to lower mortgage insurance costs, reduced overall loan costs and potentially higher loan limits,” DeGrave said.

Freddie Mac CHOICERenovation loan

This loan allows a down payment of as little as 3.5% and lower credit scores, and can be used for second homes, investment properties and multi-family residences, although certain restrictions apply.

USDA Rural Development home repair loan

For a USDA Rural Development loan, you must live in an approved rural area and meet median income requirements in that area. Funds can help pay for many eligible upgrades and repairs.

Private or hard money rehab loan

This option can come in handy if you can’t find rehab financing elsewhere. Hard money lenders look more closely at collateral than income and credit score, as well as the home’s after-repair value. But interest rates will likely be higher and repayment terms stricter.

Home equity loan or home equity line of credit (HELOC)

Suppose you are seeking to repair or remodel an existing home. In that case, you can tap into your home’s equity by either taking out a home equity loan or HELOC, each of which has its pros and cons. “If property values in your neighborhood fall, tapping your home’s equity may backfire against you,” said Solomon.

Cash-out refinance loan

Another choice when you want to renovate or repair an existing home is to refinance your mortgage and take cash out at closing, which may be less expensive than other financing options because of current low interest rates. This option may take longer to close than a home equity loan or HELOC.

Conclusion

An FHA 203(k) loan provides a convenient means to both fix up and buy a home for as little as 3.5% down and usually at a competitive interest rate.

“If you are looking for a house that needs some work, a rehab loan is the ideal lending solution for your needs, regardless of how big or little the job is,” said Solomon.

But don’t feel obligated to commit to an FHA 203(k) loan. Explore other rehab financing choices , too.

“Each loan program has its pros and cons. A thorough understanding of your short-and long-term goals, the property and your qualifications will help determine which financing option is best,” DeGrave said.

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