You are attracted to a house that is perfectly located but it just came out of foreclosure and needs a lot of work to make it habitable. To swing the deal, you need to finance both the purchase and the required repairs. How do you do that?
I recently wrote an article dealing with the first part of this problem: financing the purchase of a house in such poor condition that it might prove unacceptable to lenders as collateral. A strategy for minimizing the risk of getting turned down for a purchase mortgage is described in Purchase a House in Poor Condition? on my website.
But getting the mortgage required to purchase a house is only one of the challenges facing the buyer when the house needs work. The second challenge is finding a way to finance the needed repairs. The standard purchase mortgage doesn’t do that because it is based on the lower of sale price or the appraised value of the home in its current condition.
An obvious solution is a second mortgage, but they are not available in the current market except where the first mortgage is too small to do the buyer any good. Second mortgage lenders are still smarting from the steep losses they suffered on second mortgages written during the go-go years leading up to the financial crisis. An unsecured personal loan would be extremely costly if it were available at all.
The solution to this problem is a mortgage on which the loan amount is based on the value of the property after needed repairs have been made. Then one mortgage would cover both a purchase and the repairs needed to make the house habitable. This is future value financing, and it is available through a special FHA program termed "203(k)." This program is available to both home purchasers and existing homeowners who want to rehabilitate their properties in conjunction with a refinance.
The Section 203(k) program is complicated because FHA as the risk bearer has to make sure that the future value of the property upon which the mortgage amount is based actually materializes. To protect itself, FHA requires an appraisal of the property’s value after completion of the planned rehabilitation, in addition to an appraisal of the property "as is."
Further, before the mortgage is insured, the lender must create a rehabilitation escrow account that contains the money allocated for expenses. FHA has procedures in place to assure that draws against this account are properly disbursed and accounted for, and that the rehabilitation work is completed.
Lenders are encouraged to participate in 203(k)s by the insurance against loss provided by FHA. However, 203(k)s are more complicated and involve more paperwork than the mainstream FHA program, and participating lenders use specially trained staff. As a result, many lenders don’t offer 203(k)s. Lenders that do offer them charge a rate above that on standard FHAs — figure on paying about 0.25 percent more. HUD provides a list of Section 203(k) lenders; see FHA 203(k) lenders. I have started a project to certify Section 203(k) lenders, but it is not yet ready.
The borrower looking for future value financing must deal with multiple players. In a typical case, the real estate agent who shows a potential buyer a house in need of work will recommend a lender who will preapprove the borrower for a 203(k). The preapproval is based on estimates of sale price and repair costs. The sale price estimate is provided by an appraiser selected by the lender who values the property on both an as-is and after-repairs basis. The repair cost is provided by a licensed general contractor who is usually recommended by the lender.
In addition, if the repair costs are more than $35,000, FHA requires the borrower to retain a HUD-approved consultant to help manage the process. Among other things, the consultant prepares the required architectural exhibits, and monitors the improvements at each stage. HUD provides a list of consultants (see FHA 203(k) consultants) and sets their fee schedule, but does not warrant their performance. Lenders will usually recommend consultants that they have worked with, and this is one case where a lender referral is likely to serve the borrower well. The consultant’s fee can be included in the mortgage.
I expect to see increasing use of 203(k) in the next few years. Millions of homes emerging from the foreclosure process will enter the market, and many of them have been neglected and need work.
Thanks to Ritchie Love and Robert Obday of Monarch Bank for help on this article.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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