Making repairs or renovations to your home can instantly increase the value of your home. This means you receive a bigger return on your investment. Today, however, many homeowners lost value in their home. The housing crisis caused values to plummet. Many areas have not fu lly recovered. If you live in one of these areas, you may not have enough equity in your home to take out a home equity loan. Generally, lenders allow a maximum LTV of 80% with a HELOC or home equity loan. There have always been other options, but many people overlooked them. They are the home renovation refinance programs. There are two that are the most popular – the FHA 203(K) and the Fannie Mae HomeStyle Renovation Loan.
The Home Renovation Refinance Loan Basics
Just as standard conventional loans and FHA loans have differences, so do the FHA 203(K) and HomeStyle Loan. They also have many similarities, though.
The premise of each loan is the same. You borrow money based on the proposed value of the home after the renovations. An appraiser helps the lender determine this future value. Each loan allows different LTVs though. The FHA allows you to borrow up to 110% of the future value of the home after repairs. The Fannie Mae loan allows you to borrow up to 95% of the value of the home.
Both the FHA and Fannie Mae loan only require one closing. They disburse the funds to pay off your current mortgage right away. The old bank has its money and the remaining funds sit in an escrow account. Before you close, the lender will approve any renovations you will make with the funds. The lender then disburses the funds according to a predetermined schedule that you, the contractor, and the lender agreed on.
Qualifying for Both Loans
It is probably no surprise that the FHA and conventional loan have different requirements. FHA loans are known for leniency while conventional loans have tighter restrictions.
For example, a borrower with less than perfect credit will likely have an easier time with the FHA program. The industry standard is a credit score of 640. However, because the lenders can decide for themselves, you may find a lender willing to accept a lower credit score. The conventional loan, on the other hand, would probably not allow a score below 680 without serious compensating factors. This means you can make up for the less than perfect credit history with ample reserves, a low debt ratio, or stable employment. Even then, lenders are often weary of lower credit scores for conventional loans.
Just as the FHA loan offers more leniencies in personal qualifying factors, they have stricter property guidelines. In fact, you can only use the FHA 203(K) loan for a primary residence. If you want to refinance and renovate an investment property or second home, you have to use the Fannie Mae HomeStyle program. The FHA also denies any renovations they consider “luxurious.” Think swimming pools or unnecessary cosmetic changes in a home. The HomeStyle program does not restrict any renovations based on luxury.
Affording the Loan
Chances are you will have to pay mortgage insurance for each loan type. The FHA loan requires mortgage insurance upfront and monthly. The Fannie Mae loan only requires PMI if you borrow more than 80% of the value of the home. Since you need money to pay for renovations, chances are you will borrow more than this amount. If you are not used to paying mortgage insurance on your current loan, this could be an adjustment for you.
There are key differences between the mortgage insurance payments:
- FHA mortgage insurance is usually a lifelong payment until you pay the loan off. This could add a significant amount of money to what you pay for the house in the end. You can estimate the amount you pay at 1% of the outstanding principal balance. The amount will decrease every year, but not by an extreme amount.
- You can cancel the HomeStyle PMI once you owe less than 80% of the value of the property.
Of course, you can refinance out of the FHA loan in the future if you have the qualifying factors. This means keeping your credit score up and getting the LTV down to at least 95%. It would make sense to wait until you are down to less than 80% though, so you can eliminate all mortgage insurance on your loan.
If you qualify for both loans, compare the monthly payments and the insurance amounts. Then determine how long you plan to stay in the home. For example, if this is your forever home, take the loan with the lowest insurance payment. This allows you to minimize the extra money you pay towards insurance. If you only plan to stay for 5 years or so, focus on the interest rate and the lowest payment. Chances are you will not refinance out of this loan or see a huge profit when you sell, so minimizing what you pay monthly can help you save.
The bottom line is the best home renovation refinance program depends on your circumstances. If you have great credit and it is a primary residence, do not overlook the Homestyle program. On the other hand, if you have mediocre credit or you need more than 100% of the future value of the property to make the renovations, the FHA 203(K) loan is a great choice.
Either way, you can secure a loan that will help you make the changes you want. Try to focus on changes that directly impact the value of the property to see the greatest return. You can consult with an appraiser or architect to determine the best changes to make. Any small changes that do not impact the value can wait until you have the cash to make those changes. In the meantime, make the most of your investment and look forward to a profitable future.