Purchasing a Home in Need of Repair

The purchase of a house that needs repair is often a catch-22 situation.  The bank may not lend money to buy the house until repairs are complete, but repairs can't be done until the house has been purchased. The U.S. Department of Housing and Urban Development (HUD) has a program, called Section 203(k), that may help resolve this issue.

The program is designed to enable you to purchase or refinance a property using a loan that includes the cost of repairs and improvements. The FHA insured 203(k) loan is provided through approved mortgage lenders nationwide.

Problem with conventional funding.  With most mortgages, the lender will not close the loan and release funds unless the value of the property provides adequate loan security. When rehabilitation is involved, this means that a lender typically requires the improvements to be finished before a long-term mortgage is made.  When a homebuyer wants to purchase a house in need of repair or modernization, they would typically need to obtain interim financing to purchase the home, additional interim financing to perform the repair work, and then a permanent mortgage to pay off the interim loans after the work has been completed.  These interim acquisition and construction loans often have relatively high interest rates and short amortization periods.

Section 203(k) program solution.  HUD's Section 203(k) program enables a borrower to get just one mortgage loan, at a long-term fixed (or adjustable) rate, to finance both the acquisition and the rehabilitation of the property. The mortgage amount is based on the projected value of the property after the work is completed, taking into account the cost of the work.

Section 203 (k) loan down payment.  The down payment requirement for an owner-occupant is approximately 3.5% of the acquisition and repair costs of the property.

Process for obtaining a Section 203 (k) loan.  Here are the typical steps for obtaining a 203(k) loan:

  • A potential homebuyer locates a fixer-upper, does a feasibility analysis of the property with their realtor, and and then executes a sales contract. The contract should state that the buyer is seeking a 203(k) loan and that the contract is contingent on loan approval based on additional required repairs by the FHA or the lender.
  • The homebuyer selects an FHA-approved 203(k) lender and arranges for a detailed proposal showing the scope of work to be done, including a detailed cost estimate for repairs.
  • An appraisal is performed to determine the value of the property after renovation.
  • If the borrower passes the lender's credit-worthiness test, the loan closes for an amount that will cover the purchase or refinance cost of the property, the remodeling costs and the allowable closing costs. The loan amount will also include a contingency reserve of 10% to 20% of the total remodeling costs, which will be used to cover any extra work not included in the original proposal.
  • At closing, the seller is paid off and the remaining funds are put in an escrow account to pay for the repairs and improvements during the rehabilitation period.
  • The mortgage payments and remodeling begin after the loan closes. If the property will not be occupied during construction, the maximum cost of repairs can be equal to the amount of six mortgage payments.  And the construction period cannot exceed six months.
  • Escrowed funds are released to the contractor during construction through a series of draw requests for completed work. To ensure completion of the job, 10 percent of each draw is held back until the lender determines there will be no liens on the property.