The FHA 203K rehab loan is the holy grail of loans available to first time home buyers looking for a way to buy a fixer upper with low capital to begin their investing career. The problem is not many people know much about how to actually pull it off, here’s how I did. Twice in one year.
I used an FHA 203K rehab loan to buy a four unit apartment building and a conventional version to buy a single family residence. Here’s how I did it, what I needed to succeed at it and what I learned from the process.
But first, what is the FHA 203K Rehab Loan?
This is a loan specifically designed for home owners, to purchase a property in need of repairs and to have the costs of the repairs rolled into the mortgage. The $30,000 you’ll need to fix the house will be amortized over the duration of your mortgage. Basically, you’re getting assistance to buy a fixer upper you otherwise couldn’t because it wouldn’t pass for financing in its current condition and they are bankrolling your rehab.
I’ll break this down into five key parts to keep it simple
- Advantages / Disadvantages
- Choosing The Lender
- Finding The Contractor
- The Rules
- The Lessons Learned
The FHA 203K is the secret weapon of the new investor looking to occupy the project once complete. While a cash investor needs the full amount to buy a property, you can get into it for 3.5% of the purchase price + renovations. The playing field has suddenly been leveled. While it will take more work to get your offer accepted you are no longer sidelined while the cash investors snap up all the fixers in your market.
Also, this loan can be used to purchase Multi-Family properties of up to four units. This is how the FHA 203K is leveraged to its full potential. You can now buy a fixer up apartment building for as little as 3.5% down, live in one unit and rent out the other three. You can literally own your first apartment building for under $20,000!
There are disadvantages, some that last the life of the loan and others that are more short term. The biggest drawback is that you will be required to pay mortgage insurance on your loan and it isn’t cheap. On a $360,000 mortgage I pay roughly $300 a month on insurance to protect the lender should I ever default on the loan. Also, these loans are known for being complicated and often fall out prior to closing. This means your offer could look very weak to the listing agent who is guiding their seller on which offer to accept. Because of this it is critical that you are well prepared and on top of your game to get your offer accepted, the loan to go through and the deal to close.
Choosing the Lender
When planning to go the route of the FHA 203K you want to research a lender who is very familiar with the process. You should find someone who specializes in handling these loans, without my allstar lender I doubt my deal would have closed. Like agents most lenders will reach for any action they can get even if they aren’t best suited to take it on. This isn’t the type of lender you want. If they haven’t recently completed a rehab loan keep looking.
Remember, your lender will be instrumental in you getting your offer accepted and closing the deal. I found mine through referral from a local REI club, this individual specialized in these loans and was on top of every part of the process. He even contacted the listing agent to vouch for my financials and ability to handle this project. These are the things your lender must be ready to do for you to show solidarity, strong communication and a willingness to get things done.
Finding the Contractor
I’ve completed two rehab projects funded through a mortgage, one of those went very well (203K) and one of them was a disaster (Conventional) the contractor was the element that caused me all of my problems in my second project. He was so awful that Spike TV busted him for his work on another project, you can read more about that here (Spike TV Handles a Bad Contractor For Me).
The difference between the first and second contractor on paper were minimal if any. Both were professional, fast to respond and tech savvy. My only error with the second contractor was not checking his references on past projects. Had I done this he would have never gotten the job, he was a hack.
So let’s focus on the first contractor and the qualities that made the project a breeze. There are two types of FHA rehab loans, a streamlined and non-streamlined. As you’d guess you want to stick with a streamlined, it means less involvement by the lender and a quicker simpler process for you to get approved and close the deal but it limits your rehab budget. A non-streamlined project requires a consultant to monitor the project (at a cost to you) and it adds more moving parts to an already complex process.
My rehab budget was $33,000 just at the threshold to keep it in the streamlined category. Anything above that amount would have to come out of my pocket to keep things simple. I shopped several contractors and most were scared away by the paperwork and processes involved to be approved. You need a pro, who is fully insured, has workman’s comp and is well-funded because the money comes in two draws 1/3 up front 2/3 at completion.
The key to making this work is accepting you will be paying more for their services than most other contractors. They have higher fixed costs due to being legitimate and their higher level of professionalism is going to cost you. Don’t cut corners on contractor’s they can cost you the deal if they can’t handle the paperwork during your application process. Your contractor should be expected to deliver on the bid supplied to your lender, manage the project accordingly and stay in steady communication with you and your lender throughout the project. There will be a final inspection by a third party hired by your lender, they will expect to see copies of permits and will inspect all work to ensure it was not only performed but done properly.
*Rules change, this is based on my experience. Please consult a professional to verify all information*
FHA is synonymous with one rule in particular. You MUST occupy the property. These loans are designed to allow home owners the opportunity to buy a fixer upper. So, if you do not intend to live in the property it would be wise to consider another option which are available and will be discussed in another blog post.
Besides the occupancy rule, the requirements of your contractor and local building code are by far the most important rules to pay close attention to. Your contractor must get ALL permits needed for the scope of work and don’t even think about cutting corners. Your project will be inspected throughout its duration and the bank doesn’t play any games. This means you and your contractor should be well prepared for the cost and time involved for pulling permits, adhering to local building code and routine inspections from the city.
As mentioned before your contractor will be required to have valid insurance, workman’s comp and a contractor’s license. There is no budging on this, don’t even bother. You want a pro who can work with you and the bank effortlessly.
Overall, the experience was positive. I got into a four unit apartment building for under $25,000, a fraction of what it would have cost a cash buyer. This experience taught me the process well enough to utilize the same loan in a conventional format to buy a second property with another rehab loan. Being able to roll your repair costs into 4% fixed rate 30 year mortgage and leverage every possible advantage available to me is how you get ahead in the investing world. This is a fantastic program available to those who have the guts to take it on.
The most important lesson learned was the importance of mentors. They were the one thing that allowed me to succeed throughout all of the hurdles and failures. Fellow investors who referred to me the all-star lender, referrals for the first contractor, mentors who guided me on how to manage the tenants I inherited who were selling heroin. All of the kind people who took the time to help me learn from their past experiences to ensure I didn’t have as steep a learning curve as they had.
Without the mentors neither of these deals would have happened. Don’t be shy asking for help, advice and guidance experienced investors are often happy to help a friendly and eager newcomer. They usually see a little of themselves in us and remember their humble beginnings in real estate investing.