Rehab Loan: What Is It and How Does It Work?

A rehab loan is a home improvement loan you can use to buy a house that needs some fixing. These allow buyers to borrow enough money to buy a property and cover the renovations and repair expenses a fixer-upper home may need.

Buyers can use these loans to purchase houses that need work, situated in locations they otherwise couldn’t afford because properties that don’t need as much work aren’t on the market in these neighborhoods.

In this article, we explore rehab loans, how they work, the process of applying, and their advantages and disadvantages to help you decide whether this financing option will suit you.

What Is a Rehab Loan?

Also known as the FHA 203k loan and FHA construction loan, a rehab loan allows you to finance both the property itself and needed repairs and renovations. A 203k rehab loan tackles a common issue when purchasing a fixer-upper house - lenders often don’t approve loans for properties that require major repairs.

However, 203k lenders track and verify repairs when using a rehab loan and are willing to approve loans on houses they wouldn’t otherwise consider. Even so, for a lender to approve financing, the property must meet some safety and livability standards determined primarily by the FHA home appraisal. And if the property is too rundown, you won’t be able to use a rehab loan.

A 203k rehab loan program can be an excellent option for buyers on a tighter budget who want to purchase an older house and fix it instead of buying a more expensive home ready for immediate use. However, even buying a fixer-upper home can involve some hidden costs.

How Does a Rehab Loan Program Work?

The process for a rehab loan is similar to that of regular home buying, with some differences. First, you need to apply for a loan with a 203k-approved lender and get approved for it. Then, you need to choose a contractor and get bids (estimates for the repairs). After that, you must close the loan and complete the repairs. And once you’ve done that, you’re free to move in.

How to Get a Rehab Loan?

To qualify for a rehab loan, you must meet specific requirements outlined by the Department of Housing and Urban Development (HUD), including:

• Finding a home that may need some repairs or updating
• Finding a qualified lender
• Meeting all lender requirements, including debt-to-income (DTI) ratios, credit scores, and proof of income.

Repairs You Can Do with a Rehab Loan

There are two types of FHA 203k loans, and the extent of the repair work will depend on the loan you choose.

Limited 203k Rehab Loan

Formerly known as the Streamline 203k, Limited 203k loan allows you to do most cosmetic repair work, such as bathrooms and kitchens. The stated cost limit is $35,000, but an FHA 203k loan requires a contingency equal to 15% of the total bids.

This contingency is a “just in case” fund to cover costs exceeded by your contractor, and if this fund isn’t used, it’s credited back to you. This means that your actual maximum expenses would be approximately $31,000.

With the Limited 203k loan, most non-luxury, non-structural items are allowed, including:

• Bathroom and kitchen remodels
• HVAC replacements and upgrades
• Appliance replacement
• Flooring and carpet
• Painting
• Roofing replacement
• Energy-efficient home improvements
• Septic system improvements
• Repairing health and safety issues, etc.

However, you can’t do anything structural like adding more rooms, moving load-bearing walls, or changing the house's footprint. Nevertheless, many buyers choose this option because more lenders offer it than the standard rehab loan, and the process is more streamlined than the standard option.

Standard 203k Rehab Loan

With this option, you can do almost anything you want to the property, except add luxury amenities or non-permanent changes. This includes:

• Converting a single-family home into a 2-, 3-, or 4-unit house and vice versa
• Structural changes
• Connecting to public water or sewer
• Larger landscaping projects
• Moving the home to another site, etc.

Things You Can’t Do with FHA Rehab Loans

Although FHA rehab loan guidelines allow a lot, some things are unacceptable, such as minor landscaping, projects that take longer than six months, or adding a luxury amenity like a swimming pool, tennis court, or barbecue area.

Using a Rehab Loan for Refinancing

While people typically use a rehab loan when buying a house, it can also be used for refinancing. You can use this refinancing option if you have at least $5,000 in improvements.

The lender will order an appraisal that shows the as-is or current home value and the improved value after improvements. Your maximum refinance loan amount is subject to FHA loan limits and the lowest of the following calculations:

• The as-is value plus rehab expenses
• The existing debt before rehab plus the assessed cost of allowable closing costs and improvements
• 110% of the post-improved value multiplied by 97.75%

The lender must use the acquisition cost plus the documented rehabilitation costs for your maximum loan amount if you have owned the property for less than a year. Moreover, you don’t need an existing FHA loan to use an FHA rehab loan for refinancing

What Are the Benefits of a 203k Rehab Loan?

FHA rehab loans have many benefits. Here are some of them:

• Return on investment: A fixer-upper home can accumulate a significant return on investment (ROI) as its value increases from repairs and renovations.
• Customizing your home: A limited rehab loan funds non-structural, value-adding changes to personalize the house, including flooring, paint colors, cabinetry, countertops, etc.
• Fairly lenient qualifications: FHA 203k loans include fairly lenient requirements regarding credit scores and histories, DTI ratios, and loan limits.
• Small down payment: With only 3.5% of the selling price down at closing, 203k loan down payments are considerably lower than conventional loans.

What Are the Drawbacks of a 203k Rehab Loan?

While rehab loans have many advantages, there are also several drawbacks that come with them, some of which are listed below:

• A limited number of units in the home: FHA rehab mortgages allow buyers to buy multi-family houses, but they can’t exceed more than four units.
• Not all upgrades are covered: All repairs and renovations must be outlined and itemized before approval. It’s a good idea to check specific dollar amounts and coverage items too.
• Not great for those who need a move-in-ready home: Buyers who don’t want to have to make any major changes to their new home would prefer a turnkey house. They would benefit more from other loan options.

Conventional Rehab Loans

Besides FHA-approved 203k loans, there are also conventional rehab loan options, including the HomeStyle Renovation Mortgage from Fannie Mae and the CHOICERenovation loan from Freddie Mac.

Fannie Mae HomeStyle Renovation Mortgage

This loan’s original principal can’t exceed Fannie Mae’s maximum loan limit amount. Borrowers buying a house can’t incur rehab costs more than 75% of the lesser sum of the purchase price of the home plus repair and improvements expenses or the as-completed appraised value of the home.

Freddie Mac CHOICERenovation

These loans can also be applied to investment properties or second homes. Similar to Fannie Mae’s HomeStyle loans, this mortgage is available at a 15- or 30-year term and has a lower DTI, down payment, and credit requirements.

Thinking of Increasing the Value of Your Home?

After reading this article, you have a good idea about whether a rehab loan would suit you. While these can be an excellent option for buyers on a budget, rehab loans may not be necessary if you’re looking to increase the value of your home to sell it for more money.

There’s a much easier way to sell your house, and you don’t have to take out a rehab loan to make any improvements to increase its value. SleeveUp Homes will buy your home as-is for top dollar. Check how much you can get for your property by requesting a no-obligation cash offer and see for yourself.