How to finance a fixer-upper home

As home prices and interest rates continue to rise, many of today’s homebuyers are struggling to keep their monthly mortgage payments affordable. But for those who are willing to buy a lower-priced home that needs a little TLC, there’s a glimmer of hope: New listings advertised as fixer-upper homes were up 10% annually in June, according to data from Realtor.com.

Still, buying a fixer-upper isn’t always the seamless undertaking shown on reality TV shows — especially when it comes to financing. Some mortgage programs have strict property requirements, which can pose a problem for buyers who lack the cash to make urgent repairs upfront.

For homebuyers who don’t mind putting in a little sweat equity, though, there are several types of fixer-upper mortgages that roll the cost of home improvements into your total loan amount. If you’ve decided to buy a diamond in the rough, a renovation mortgage may be the right home financing option for your needs.

Types of Mortgages for Fixer-Uppers

	FHA 203(k) Loan	VA Renovation Loan	Conventional Rehab Loans
Maximum Renovation Costs	Up to the purchase price plus rehab costs or 110% of the home’s as-completed value, whichever is less	Up to 100% of the home’s as-completed value, determined by a VA appraiser	Up to 75% of the purchase price plus rehab costs or 75% of the home’s as-completed value, whichever is less
Construction Restrictions	Funds may only be used for eligible projects	Funds may only be used for eligible projects	Funds can be used for any renovation or repair project
Contractor Requirements	Must use FHA-approved contractors	Must use VA-approved contractors	Contractors must be licensed only where required by state law
Minimum Down Payment	3.5%	0%	3%
Minimum Credit Score	As low as 500, depending on down payment	Not specified by the VA, but some lenders have a minimum of 620	Typically around 620, depending on the lender
Loan Fees	Origination fee, typically 1.5% of the loan amount, plus closing costs	VA funding fee between 1.4% and 3.6% of the total loan amount	Fees and closing costs vary by lender
Contingency Reserve	Up to 20%	Up to 15%	Up to 15%
Mortgage Insurance	FHA mortgage insurance is required until you sell, refinance or repay the loan in full	Not required	Private mortgage insurance is required until your loan-to-value ratio drops below 80%

FHA 203(k) Loans

The Federal Housing Administration’s 203(k) loan program gives mortgage borrowers a way to buy and renovate a fixer-upper. Unlike a typical FHA home loan, it includes the purchase of the property as well as the cost of repairs and renovations in the mortgage amount. There are two types of FHA rehabilitation loans: limited 203(k) loans and standard 203(k) loans.

Limited 203(k) loans are for homes that need minor improvements, repairs and upgrades costing up to $35,000. Small projects may include kitchen remodeling, interior repainting or new flooring. However, a limited 203(k) loan doesn’t cover structural repairs like room additions or basement conversions.

Standard 203(k) loans are for major repair and rehabilitation projects and must be overseen by an FHA-approved consultant. With a standard 203(k) loan, you can tackle larger improvements like structural repairs, roof replacement and plumbing work. However, the FHA won’t let you use the funding for luxury projects, like swimming pool construction.

The maximum improvement cost for a standard 203(k) loan is limited to the purchase price plus rehab costs or 110% of the home’s value once repairs are completed, whichever is less. Standard 203(k) loans may only be used for projects costing at least $5,000.

[Read: Best FHA Loans.]

VA Rehab Loans

Active and retired military personnel who meet the service requirements for a Veterans Affairs loan may be eligible for a VA renovation loan. Like a standard VA purchase loan, a VA rehab loan allows you to purchase a property with 0% down, no mortgage insurance and competitive interest rates. And like an FHA 203(k) loan, this type of VA loan lets you roll the cost of necessary home improvements and repairs into the cost of the mortgage.

With a VA renovation loan, you can borrow up to 100% of the home’s estimated post-renovation value. The funds can only be used for repairs and upgrades that are necessary to improve the safety or livability of the property, such as replacing heating, ventilation, air conditioning, electrical or plumbing systems. VA rehab loans can’t be used to make major structural repairs, like teardowns and rebuilds.

[Read: Best VA Loans.]

Conventional Renovation Loans

In addition to government-backed home renovation loans, there are a few conventional loan programs that include the cost of repairs in the mortgage amount: Fannie Mae HomeStyle and Freddie Mac CHOICERenovation. For both options, you’ll need to find a lender that participates in this mortgage program.

Fannie Mae’s HomeStyle Renovation Loan is a conventional mortgage that includes financing for home improvements at the time of purchase or during a refinance. For homebuyers who are purchasing a property, the maximum renovation costs are 75% of the sum of the purchase price and rehab costs, or 75% of the as-completed appraised value of the property, whichever is less. Homeowners who refinance can borrow up to 75% of the as-completed appraised value of the property to pay for repairs.

Freddie Mac’s CHOICERenovation Mortgage is similar to the offering from Fannie Mae, with the same 75% renovation budget threshold. But Freddie Mac also offers a streamlined version of this loan, the CHOICEReno eXPress, for buyers with smaller rehab budgets. With the eXPress option, you can borrow up to 15% of the home’s value for renovation costs.

Unlike a government-backed rehab loan, the improvement funds from Fannie Mae and Freddie Mac renovation mortgages can be used on any project, including home additions and inessential upgrades. You can also use any licensed contractor as permitted by state law, without the need for a 203(k)-approved consultant.

Pros and Cons of Fixer-Upper Mortgages

Pros

— There is typically less competition among homebuyers for a home that needs urgent repairs.

— You stand to gain equity when the work is done, even after accounting for the cost of renovations.

— You can choose the fixtures and finishes that suit your taste.

Cons

— The process can be complicated, between completing mortgage paperwork and hiring contractors.

— You may have to put aside a contingency reserve to be used if there are issues with the repair work.

— You risk taking on a more complicated project that exceeds your initial budget and construction timeline.

— Interest rates tend to be higher on renovation loans than they are on traditional mortgages.

— The costs of permits, inspections, contractors and appraisers can add up quickly.

— Not all lenders offer rehab mortgages, and they can be difficult to find.

[Read: Best Home Improvement Loans. ]

How to Choose the Best Renovation Financing Option

There’s no one-size-fits-all financing solution for mortgage borrowers who are buying a fixer-upper. Here are a few things to consider when choosing a fixer-upper loan:

— Consider the scope of your work. Someone who is buying a home that just needs minor aesthetic improvements will have much different financing needs from someone who plans to buy a home in need of major repair.

— Determine whether you meet the eligibility requirements. For example, you’ll need a Certificate of Eligibility, or COE, to qualify for a VA renovation loan. If you have a lower credit score, you might have the best luck through the FHA’s 203(k) loan program.

— Get a few estimates for the work that’s needed. Reach out to the proper contractors, such as plumbers, electricians and HVAC technicians, to find out how much each project will cost. Once you have a better idea of your total renovation budget, you should be able to narrow down your borrowing options.

— Compare borrowing costs for each product. Interest rates vary widely among types of mortgages, so it’s important to consider the long-term cost of borrowing a renovation loan. You can find the mortgage rate, monthly payment and closing costs in your loan estimate.

Another Way to Finance a Fixer-Upper

FHA 203(k) loans and other rehab loans may be the right choice for some homebuyers, but they’re not ideal for DIY renovators with relatively smaller remodeling projects. If you want to buy a fixer-upper without the limitations of a renovation loan, there’s another common strategy to consider:

— Borrow a conventional loan to cover the purchase of the home. Note: Some government-backed mortgages, like FHA and VA loans, have strict property requirements that make it difficult to close on a fixer-upper.

— Take out a home improvement loan, such as an unsecured personal loan or line of credit, to pay for your renovation project.

— Refinance your original mortgage when the work is completed. This effectively allows you to tap into your home’s increased equity to pay off the rehab loan at a lower rate.

A separate loan may be a good option if you have the skills and equipment needed to complete the repairs yourself, or if you plan on living in the home while you renovate it. But if a property is in dire need of expensive professional repairs done by a licensed contractor before you can move in, then a fixer-upper mortgage may be a more favorable option.

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How to Finance a Fixer-Upper Home originally appeared on usnews.com