I am occasionally asked about construction/renovation loans or the FHA 203k loan (which is FHA’s version of construction/renovation loan), so I wanted to write an overall analysis/opinion of these loans. They are very complicated, and a lot of sellers will not wait for the time period needed to process a loan like this. I’ll explain below.
A construction/renovation loan is typically used when you are building a home from scratch, or have a large renovation of an existing home. The initial “acquisition loan” to buy the house and then start the renovations is usually an “Interest Only” loan, based on “Prime Rate”. So you may pay Prime Rate + 1%, for example. A bank will usually restrict your time period on the renovations, for example they may give you 6 months to complete the renovations.
After the renovation is over you get a “permanent loan”, with a market rate for a traditional loan (like a 30 Year Fixed Rate), with the rate being determined at the time the renovation is complete. Hence, there is some interest rate risk, since you won’t get your “permanent loan” with a final fixed rate, until the renovations are complete. If you found a house now, went to closing in 3 months, and finished your renovation in 6 months, you’d end up with market rates for your permanent loan 9 months from the start of the project. Most banks will not lock-in your rate 6 months away from settlement, let alone 9 months. This could be quite a rate risk, not having a locked-in rate through a half year or more of a large renovation project.
Obviously a benefit with a finished home, not needing renovations, is that you lock-in an interest rate right away, removing a lot of risk. A construction renovation loan is complicated in that the banks want to: -pre-approve, in advance, your plans and specs.
-pre-approve your General Contractor
-they want to see a draw schedule for the planned cash draws over the course of the renovations.
-and a bank will NOT let a homeowner/borrower act as their own General Contractor. So you’d have to get a contractor and architect/draftsmen, all in advance, to even have the loan approved as a renovation loan.
There is usually a 4-6 week lead time to get plans drawn up. And since these loans are so complicated they take longer for a lender to process them, after receipt of the plans and the choice of builder. And that is a hassle and delay many sellers won’t wait for. A seller wants to sell their house and settle on it in 30-45 days, waiting 6 weeks for plans and another 6 weeks for loan approval, is usually not in the cards.
And last is the overall hassle with contractors, which short of childbirth, personal bankruptcy, and getting hit by a car; could be one of the most painful and emotional experiences you will ever deal with. I have done a few renovations, and I don’t think I’ll do another as long as I live. The cost overruns are a certainty, delays are a virtual guarantee, and trying to find a trustworthy and efficient contractor (general contractor or sub-contractor) is like finding a needle in a haystack.
Go to this page on my website: Loan Tracking, and at the bottom right of the game board, click on the “Contractors” button. It’s got some other good data on the contractors. My suggestion would be to try and find a resale home that is done the way you want, or at least close to the way you want. Then maybe it just comes down to a much smaller amount of money that you could fund on your own, or pay as you go, by doing smaller projects on your own. I am aware that most places will never be exactly what you want. But to avoid the hassle of a renovation and a renovation loan; I’d find something close to what I want, that maybe just leaves the buyer painting a few rooms, remodeling a bathroom, and putting in some new appliances.
If the above has not clearly shown the hassle associated with a renovation loan, the below checklist of some of the items needed may help: Here is an overview of much of what a bank may need for a renovation loan:
-plans & specs
-contract between borrower and builder
-title work and recent survey
-provide evidence of Builder’s General Liability Insurance for at least $500,000 (sometimes $1mm or more).
-need proof of Builder’s Risk Insurance equal to at least the loan amount
-copy of builder license
-pre-closing conference call between bank rep., builder and borrower
-draws are based on % of work complete, no draws on stored material
-draws are wired directly to builder, or by joint check to builder and borrower
-once all documentation is received, the bank will order the inspection of the property, and the draw is released based on items completed
-complete a draw request form for each draw
And more, and more, and more….. Unless you have a lot of time, and an enormous amount of patience, I’d stay away from renovating a home that you need to get a renovation loan for. If you have a lot of cash, and can do a renovation using your own cash, that is another story. Although using your own cash does not alleviate the hassle of construction delays and cost overruns, it deletes the major hassle of renovation loans. I think renovating or building your own is a fun, romantic notion, but its probably best left to the pro’s who will sell it to you when its finished.