Rehab loans are a unique financial vehicle used to assist real estate investors in buying and rehabilitating troubled properties. Rehab loans give investors an avenue for buying properties in need of significant repair or remodeling, with the loan paying both the acquisition cost and rehabilitation expense.
The major benefit of a rehab loan is that the investor can factor the cost of rehabilitation in the loan, instead of securing the purchase and the funding for rehabilitation in segments.
The loan amount is usually calculated on the after-repair value (ARV) of the property, estimated market value after repairs are made. For individuals who intend to flip houses or lease homes that need extensive repairs, rehab loans prove to be a useful tool for investments that can yield profitable returns. Rehab loans suit homes with extensive damage but potential to be worth much after repairs.
Types of Rehab Loans
There are a variety of various types of rehab loans that exist for investors to use, two of the most well-known being the FHA 203(k) and the Fannie Mae HomeStyle Renovation loan, which are not hard money loans, but similar. Both loans allow borrowers to finance the purchase of the property and the cost of renovations, but they differ in their characteristics that are appropriate for different kinds of investors and projects.
The Federal Housing Administration-insured FHA 203(k) loan is a government program that is designed for lower-to-moderate income borrowers and bad credit borrowers.
This loan is usually employed by first-time homebuyers or new renovators because it has softer credit terms and lower down payments compared to conventional ones. The FHA 203(k) loan exists in two varieties: the Standard 203(k) loan and the Limited 203(k) loan.
The Standard mortgage is utilized for bigger renovations, including structural work, and the Limited mortgage is utilized for minor projects, including cosmetic improvements or repairs.
Another option is the Fannie Mae HomeStyle Renovation loan, which is a conventional loan that is less limiting in terms of the properties to which it can be applied. It allows for additional high-end remodels and can be applied to owner-occupied and investment properties.
It tends to have better credit scores and larger down payments, though, than the FHA 203(k) loan. Both of them offer an excellent way of financing for investors, but it is merely a matter of choosing the proper loan depending on the size of the project and the investor’s budget.
How Rehab Loans Work for Investment Properties
When one is seeking a rehab loan, the process differs from that of a traditional loan. The amount of the loan is typically determined by the lender using the after-repair value (ARV) of the property, which is the projected market value once all the repairs have been done.
According to this link, it means that the loan does not consider the current state of the property, but rather its potential once the repairs are done. The investors have to apply for the ARV by presenting detailed plans of the restoration with contractor bids, timelines, and budgets.
This information is then used by the lenders to analyze the feasibility of the project and confirm that the investor has a good plan for finishing the project. These are disbursed in phases, with the first disbursement towards purchasing the property. The future releases are based on the work done on the renovation.
The money is advanced by the lender in the form of draw payments released after the completion of particular phases of the rehab work. For instance, after the foundation has been dealt with by a contractor, the lender can release the next phase of the funds.
Inspections need to be carried out before every draw to ascertain whether the work is being performed according to plan and in the correct manner. This sequential disbursal of funds ensures the protection of the lender since it ensures that monies are not disbursed until the work is completed to the agreed level.
Benefits and Drawbacks of Rehab Loans
Rehab loans are applicable for cosmetic and structural upgrades, depending on the type of loan. Such flexibility allows investors to improve the property to raise its market value and profitability. Another advantage of rehab loans is that they are accessible to various types of borrowers, including those who do not qualify for conventional financing.
For instance, the FHA 203(k) loan permits those with below-average credit or lower incomes to qualify for financing to rehabilitate (source: https://money.stackexchange.com/questions/162677/how-much-rehab-partial-rebuild-can-be-done-while-keeping-existing-mortgage). Moreover, rehab loans offer investors a chance to finance properties that are not eligible for conventional ones because of their status and give investors a chance to revive aged properties and transform them into assets that increase value.
Rehab loan utilization is not without the shortcomings that the investor must proceed with caution. Among them is a severe risk of an underestimation of renovation cost. Unexpected problems, like mold, structural damage, or old electrical systems, may occur during renovation at an additional expense.
