How to Finance a Fixer-Upper: 4 Ways You Might Not Know About

Government-sponsored loan programs make buying a fixer-upper property and upgrading it to your dream home an easier process than you might expect.
Last updated Feb 1, 2021 | By Lee Huffman
How to Finance a Fixer-Upper

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With the real estate market so competitive, some buyers are turning to distressed homes that are more affordable but need some TLC. When you buy a fixer-upper, you can build equity quickly by rehabbing the property to make it more comparable to the homes around it. This makes fixer-uppers an attractive prospect for many aspiring home buyers.

Unfortunately, financing with a conventional mortgage may not be available on these kinds of home purchases. But there are some loan products and loan programs out there that can help — as long as you know about them.

In this article, we'll share how to finance a fixer-upper and provide tips on what to watch out for with these special loans.

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Why you might buy a fixer-upper

There are numerous reasons why you might consider purchasing a fixer-upper home. These properties can often be bought at a substantial discount versus fully renovated or move-in ready homes. There are usually fewer people who want to buy the ugly duckling in the neighborhood. And the repairs you make could quickly build the value of your home, which could increase your net worth.

When you buy a distressed property and make improvements to it, it’s possible for the value to increase by more than the money you spend on repairs. With this increased value, you create equity in your home. Equity is the difference between the value of your home and the debt owed against it.

For people who are handy with tools or who are willing to tackle a project, a fixer-upper home could be a way to build wealth. Not everyone has these skills or is willing to deal with the dirt, noise, and inconvenience of rehabbing a home, though. Because of this, fixer-upper homes are often less expensive and buyers have less competition when they make an offer.

How to finance a fixer-upper house

If you’re wondering how to get a loan for the purchase of a fixer-upper, it is not the same as buying a home that is fully remodeled and ready for move in. The condition of these homes can vary widely and the lender needs to be comfortable with your ability to convert the ugly duckling into a beautiful swan.

There are four specialized lending programs that can help you create your dream home out of a fixer-upper. Each program has its pros and cons, so it is important to know the details of each.

FHA 203(k)

The FHA 203(k) loan program is offered by the Federal Housing Administration, which is part of the U.S. Department of Housing and Urban Development. These loans enable homebuyers to finance both the purchase of a home and the cost of renovations in a single mortgage. For current homeowners, this program enables them to finance the rehabilitation of their existing home.

To qualify for a 203(k) loan, the cost of the rehabilitation must be at least $5,000, and the total property value must fall within the FHA mortgage limits for your area. As of Jan. 30, 2021, limits range from $356,362 to $822,375 for a single family home. Other limits apply for multi-unit properties. The house’s value is determined by the lesser of the value of the property plus renovation costs or 110% of the property after rehab.

As with other FHA loans, a 203(k) loan requires a 3.5% down payment on a purchase or 2.5% equity (including project costs) for a refinance if your credit score is 580 or higher. For FICO scores between 500 and 579, the down payment is 10%.

With a 203(k) loan, you can perform minor repairs or something more extensive, all the way to razing the home down to its foundation, on homes that are at least one year old. The projects should focus on improving the property, but not include luxuries like a pool. If you cannot live in your home during renovation, you can finance up to six months of mortgage payments in your loan. However, all renovations must be completed within six months of loan funding.

You must also hire a HUD consultant to oversee the renovation process, which adds to your overall costs. All improvements must be completed by a licensed contractor and be approved by an FHA appraiser or your HUD consultant.

Who this loan is good for: A FHA 203(k) loan is best for someone with a 3.5% down payment who is looking to do major renovations. Although rehab budgets can be as low as $5,000, the 203(k) loan is the only one that allows you to tear down the home to its foundation and start all over.

VA Renovation Loan

The Department of Veterans Affairs offers no-down-payment loans to eligible active-duty service members, veterans, reservists, and spouses to purchase and rehab a home. These loans are designed for homes that need a little work, but nothing major, such as adding a room or building a detached garage.

To be eligible, you must have enough VA entitlement for the loan amount. Although the VA does not set a minimum credit score, many lenders require a minimum of 620. You can borrow up to 100% of the cost to buy the home and pay for repairs. For existing homeowners, you can borrow up to 100% of the fully-repaired value of your home.

Although VA loans do not require mortgage insurance, a VA funding fee of .5% to 3.6% (as of Jan. 29, 2021) of the loan amount may be charged to borrowers. The percentage varies based on your down payment amount and how many times you have used this benefit in the past.

To participate in the VA Renovation Loan program, you must bring your home up to minimum VA property standards and cannot do any of the work yourself. All work must be performed by VA-approved contractors.

Who this loan is good for: VA Renovation loans are only available to borrowers with a military background or their spouses. These loans are perfect for borrowers without a down payment or homes that only need minor repairs.

HomeStyle Renovation

HomeStyle Renovation loans through Fannie Mae provide funds for a variety of renovation projects, including repairs, energy updates, landscaping, and luxury upgrades. This loan program makes it simple to pay for these updates through a conventional first mortgage.

Fannie Mae HomeStyle Renovation loan limits range from $548,250 to $822,375, depending on where you live. To qualify for a HomeStyle Renovation mortgage, the borrower needs a credit score of 620 or higher.

The LTV can be up to 97% for a single family residence. LTV is the ratio comparing the loan amount against the value of the home, which is why it is known as the loan-to-value ratio. For LTVs above 95%, the borrower must be a first-time homebuyer unless the loan is combined with HomeReady, a program for low-income borrowers.

The limit on rehab funds is based on the lesser of 75% of the purchase price plus renovation costs or the as-completed appraised value. For example, say you buy a $200,000 home that would be worth $320,000 after $100,000 repairs. The maximum repairs allowed would be the lesser of 75% of $300,000 (purchase plus repairs) or $320,000 (new value). The proposed $100,000 budget falls within the Fannie Mae guidelines because it is less than $225,000 ($300,000 x 75%).

Fannie Mae does not require the home to be habitable at the time of closing. Buyers can finance up to six months of payments while they are unable to stay in their home for repairs. Strangely enough, Fannie Mae does not require that the improvements add value to the property. And although you cannot tear down and rebuild a home with this loan, it can fund attached or detached additions.

You may be able to do some of the work yourself, but the lender has to approve the work you'll be doing. This work can constitute no more than 10% of the loan amount, and you'll be reimbursed only for the cost of the materials, not your labor.

Who this loan is good for: The Fannie Mae HomeStyle Renovation loan is good for borrowers who want to perform some of the repairs themselves to save money. It’s limit on rehab budgets is quite generous, which works well for large projects.

CHOICERenovation loan

Freddie Mac offers CHOICERevonation loans for homebuyers looking to finance a house in need of repairs. Existing homeowners can pay for repairs using these loans as well. These loans can be used for your primary residence, a second home, and even an investment property.

The LTV can go up to 97% on a single-family residence when paired with Home Possible, a loan program for low-to-moderate-income borrowers. Loan limits for CHOICERenovation loans are $548,250, but people in high-cost areas can borrow up to $822,375. Borrower credit scores must be at least 660 with less than a 25% down payment and at least 720 for a second home or investment property.

As with the HomeStyle loan described above, the rehab budget is limited to 75% of the lesser of the combined purchase price and project cost or property's post-renovation appraised value.

Proceeds from these loans can pay to renovate and repair the home and for upgrades to protect against future disasters. Fees for plans, permits, inspections, and other related costs can also be included. Up to six months of payments may be included if you are unable to live in the home during the renovation. However, the home may not be razed and rebuilt.

Who this loan is good for: The Freddie Mac CHOICERenovation loan is a good choice for primary residences, second homes, and investment properties. These loans also work well for homes that need repairs or protection from natural disasters.

Important things to know before you finance a fixer-upper

Before going down the path of buying a new home that needs renovating, there are some important things to know:

Hidden problems

There's a big difference between buying a home that is simply outdated and one that has sustained hurricane or fire damage. The outdated home may need cosmetic repairs, whereas the damaged homes may have hidden problems, such as mold, structural issues, or other costly repairs.

Rehabbing a home is like opening a present. You may have a good idea of what's inside, but you don't fully know until you start digging into it. Your remodel may start out with a budget that includes tearing out the kitchen, but then you may discover weak floorboards, broken pipes, or code violations that need to be addressed as well. Many of these items are big unknowns until you start the demolition process.

To cover these unexpected costs, fixer-upper loans require a contingency reserve between 10% and 20% of the repair budget. The contingency reserve is essentially an emergency fund for your renovation that ensures there is money set aside to cover unexpected repairs that were not part of the original scope of your project.

Don't have complete control

You may not have complete control over the improvement projects you want to perform. Some desired projects may not be eligible under all loan programs, such as adding a garage or separate structure. And certain loan programs will require that the work be performed to certain standards in order to be approved.

What the true cost is to rehab and renovate your home

You should have multiple contractors bid on your rehab project before moving forward. Ensure that each contractor is including the same scope of work to make the best comparison.

Because the true construction costs are unknown at the beginning of the project, lenders will require a contingency reserve of up to 20% of the project budget for unexpected work that needs to be done. Depending upon your lender, if this money is not needed, it can later be used to pay down your loan, to fund additional projects (with approval), or to be returned to you.

Extra costs

Depending on the condition of the fixer-upper, it may require extra consultations, inspections, and home appraisals before the lender is comfortable with approving your rehab loan and plan.

Appraisers charge a higher rate for a fixer-upper appraisal than a move-in ready home because they have to review the proposed scope of work to determine what the potentially higher value will be when the repairs are complete. Additionally, the appraiser must return when the work is done to ensure the project was completed as described in the beginning.

Other financing options to consider

These fixer-upper home loans may not be right for your property or the repairs you want to make. In that case, consider these alternatives:

Personal loan

A personal loan is usually an unsecured loan based on your income and credit. The value of your home or the repairs are not part of the decision, and there are no restrictions on how you spend the money. These loans can be easier to get, but the interest rates tend to be higher because they are unsecured. Also, the payments tend to be higher because the repayment term is shorter (usually five or fewer years). If you think a personal loan is the right fit for you, make sure to choose from among the best personal loans available.

0% credit cards

Using one of the best credit cards for home renovation could also be a potential solution, depending on the scope of your project. These cards offer a 0% interest rate period when you first get them. During this promotional period, you will not be charged any interest on the balance but you will be required to make minimum payments. The 0% APR usually lasts 12 to 21 months, at which time any unpaid balance starts accruing the regular interest rate, which will be much higher. If you can pay off your rehab bill within that time frame, this could be a good option.

Home equity line of credit or loan

Home equity lines of credit and loans are available only to those who already own a home. Tapping your home equity is considered one of the best home improvement loans because you can use that equity to increase the value of your home through repairs and renovation.

These loans carry interest rates that are similar to mortgages, but their repayment terms are shorter. HELOCs typically offer interest-only payments with a variable interest rate during the draw period (when you can withdraw funds), then convert into a term loan. Home equity loans give you all of the money upfront and have equal payments for a period of time at a fixed interest rate.

FAQs

Are renovation loans a good idea?

Renovation loans are an excellent idea for people who own or are buying a home that needs repairs. Fixing up a damaged home is a good way to increase the value of the home and build equity.

Can I buy a fixer-upper with a USDA loan?

Yes, you can buy a fixer-upper with a Department of Agriculture loan, but there are some requirements. The home must be habitable and the renovation costs cannot be more than 10% of the loan amount.

Can I do the work myself with a 203(k) loan?

Yes, if you are the DIY type, you may act as your own general contractor or do the actual repairs if you are qualified. The loan proceeds can be used for material costs, but you cannot pay yourself to do the work.

Do you pay PMI on a 203k loan?

Yes, because your LTV ratio will be higher than 80%, you will have to pay for private mortgage insurance, also known as PMI, on your loan.


Bottom line

If you are thinking about how to finance a fixer-upper, there are several government programs that could make the process easier. These programs allow you to pay for the purchase and renovation costs through a single loan. Fixer-upper mortgages tend to have higher fees than a traditional mortgage, but they charge the same interest rates as other loans backed by these government agencies.

When you're ready to buy a home that needs some TLC to turn it into your dream home, consider getting a fixer-upper mortgage through one of these programs. The best mortgage lenders can help you evaluate all your options and help you pick the right loan product for your situation.

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