What if I find a Fixer Upper? Learn How to Finance a Renovation

A common question I hear is, "What if I find a fixer upper? How do I finance a home that needs sizeable renovations?" The goal of this article is to address these questions and provide the information you need so that you know how to finance when you find that perfect fixer upper.

When looking to purchase a home to renovate, the goal essentially is to find the easiest and least expensive way to obtain funds for this renovation project. The key idea here is that there are many options to finance a renovation, with a renovation loan being one option. Hence, when looking to renovate a home, ensure to look at all your options and not limit the discussion to just renovation loans.

Before going any further, there are a few aspects of renovation loans that are helpful to understand. For example, just as the word “google” can be used for any internet search, the term “203K” often implies any type of renovation loan. Technically, a 203K is a renovation loan specifically from the Federal Housing Administration (FHA) and a good program but know there are also other renovation financing options. 

Renovation loans also differ from a traditional mortgage in a few keyways. A traditional mortgage finances a percentage of the purchase price, has a slightly lower rate and a few thousand less in closing costs than a renovation loan. In contrast, a renovation loan finances a percent of the sum of the purchase price plus renovation costs, has a higher interest rate, and costs a few thousand more in closing costs.  

Renovation loans can take 2-4 weeks longer to fund than a traditional mortgage, as time is needed to hire a general contractor, as well as obtain fully draw construction plans and specifications. Finally, know that the general contractor you hire must be licensed, and cannot be either yourself or a member of your family.

So, when is a renovation loan required? At the risk of sounding overly simple, the best way to evaluate whether a renovation loan must be used, is to ask yourself, “would living in this home be like camping?” If the home is “like camping” then the only way to purchase that home, other than paying all cash, is to use a renovation loan. 

In terms of evaluating the ‘camping’ criteria, consider whether you are exposed to the elements, have no permanent facilities, no indoor plumbing, and no permanent kitchen. Similarly, if the inside of the home is exposed to the elements (missing windows, doors, or has a hole in the roof), does not have working plumbing or does not have a functional kitchen, then we’d say the home is similar to a tent and could not be purchased without a renovation loan.

 Something important thing to remember, you can still use a renovation loan if a home is fully functional. However, it’s not a requirement, which leads into the next topic: when would a renovation loan not be an option?

Most homes are eligible for a renovation loan; however, seller may choose not to accept an offer using renovation financing. In this instance, a renovation loan could be an option, but not practical. The reason a seller may not accept an offer with renovation financing is that it takes a bit longer to close than a traditional mortgage, and renovation loans have more steps, which in a seller’s mind may be interpreted as more things that might go wrong. 

Bluntly, if there are no competing offers for the purchase of a home, a seller is more likely to consider accepting an offer with renovation financing. The key here is to ask your realtor if a seller would be open to accepting an offer with renovation financing and know there are instances where a seller will simply not consider an offer using a renovation loan.

Assuming the seller may be open to a renovation loan, we next turn the discussion to whether certain requirements of a renovation loan would be acceptable to you for your planned renovation project, and then how to select the best financing.

Requirements for a Renovation Loan are summarized below. If you are not 100% ok with all the below, it may be good to look for other alternatives to a renovation loan.

•  A licensed general contractor must be used. The contractor may not be yourself or a member of your family.
• Plans & specs for the entire project must be completed within the first few weeks of the home being under contract. AKA, these must be completed weeks ahead of the date you will officially purchase the home.
• All renovations will occur soon after the date of purchase. Some people prefer to live in their new home a few months before deciding on what renovations to complete, but this would not be an option with a renovation loan.

Many times, I’ve seen home buyers prefer flexibilities such as using an unlicensed contractor to lower costs, waiting to plan renovation until after living in the house a few months, or having renovations done over time, and not all at once.  

If you are okay with all the above requirements for your upcoming renovation project, we’ll now turn to the last consideration, which is selecting the best way to pay for renovating a home. There are three steps to finally select the best financing for a renovation project, summarized below:

1. First, you need to know the best estimate of the costs required to complete your preferred renovations. The best financing option for a $10,000 renovation will be different than the best financing option for a $20,000 renovation.  
2. Next, you need to know what financing options will be most realistic for your project. There are many theoretical ways to pay for a renovation, but most will not be applicable to your specific project. A silly example would be by winning the lottery, you could pay for a renovation project. While possible, this is quite unlikely. Below are more realistic methods, some of which may be applicable to your project:

• Renovation Loan: Typically, these have a higher interest rate and additional closing costs than a traditional mortgage, but renovation loans can fund larger projects and allow most of the cost of renovations to be financed.
• Lowering Down Payment: This option often is good for low to moderate renovation budgets, as it allows for a lower rate, less closing costs, and more control over the renovation project. For example, if the cost of a renovation was forecasted at $70,000 and you were planning a $100,000 down payment on a renovation loan, you may want to consider a traditional (lower priced) mortgage with a $30K down payment and retain the other $70K to pay the renovation out of pocket, thus not needing a renovation loan. This is only an option if the renovation costs are more than your down payment.
• Self-Fund Renovation (then Cash Out Refinance): Should you have savings, the ability to borrow against retirement or funds available from family, often one will purchase a home with traditional financing and self-fund the renovation from these sources.  After the renovation complete and the home’s value is higher, the home buyer may do a cash out refinance to have one mortgage and use the cash out proceeds to repay or replenish the sources of funds for the renovation.

You then want to quantify the cost of each realistic financing option from above (2). You want to have your lender provide costs for each of the options above that might viable or preferred, as well as have your lender quantify possible risks associated with each of those options.

Once you understand your options and know the specific costs of each, it becomes quite easy to select what financing would be the best fit for the purchase an renovation of your new home.

This was a long article but know that if you understand the above and follow each of the outlined steps, you’ll make a good decision when looking to renovate a home.