House flippers aren’t supposed to use 203(k), but…

construction delaysWe’ve written a lot lately about fixer-uppers, with articles on both finding real estate owned — or REO — properties and securing private lending for fix-and-flips. But the U.S. Department of Housing and Urban Development may have added a little more encouragement to those who seek to renovate distressed homes. While the recently upgraded program is intended for those who will be residing at the property as their primary residence, house flippers are bound to find ways around the letter of the law.

HUD’s Federal Housing Authority recently raised the ceiling for its rehab loan program by $15,000, so now you can apply for up $50,000 in the FHA’s 203(k) program. But there are restrictions — not to mention a ticking countdown timer.

“Thanks to a new rule, people buying in designated ‘Opportunity Zones’ can borrow up to $50,000 — giving them an extra $15,000 in renovating power,” Peter Miller wrote in a December post in The Mortgage Reports. “But the new rule is first-come, first-served. Only the first 15,000 applicants nationwide will be able to use the higher FHA 203k loan limit. So if you’re interested in a bigger 203(k) loan, check your eligibility and move fast.

(For more about OZs, we recently covered that in this space too.)

Beyond today’s news

It might surprise some to learn that 203(k) loans can be used for acquiring properties as well as fixing them up. The intent of 203(k)s is to eliminate an old Catch-22 of real estate investing: If the property isn’t up-to-code, you can’t get a loan to buy it, but you can’t buy it to bring it up-to-code without a loan.

“The 203(k) lets you buy and fix up a house in one transaction, allowing the lender to approve the loan despite its initial condition,” Tim Lucas writes for The Mortgage Reports.

We’d be remiss not to point out that HUD isn’t the lender. Its FHA serves as a mortgage insurer, taking a substantial amount of non-performance risk out of the loan, thus lowering the rate at which a private lender can offer it to you. FHA, by the way, is entirely self-funded. The good news is that there’s no guilt on your conscience about taking taxpayer money to finance your project. The bad news — and it’s not all that bad — is that FHA charges 1.75% upfront on your mortgage as an insurance premium, then 0.85% annually.

But not all lending institutions originate 203(k) loans and, at those that do, not all officers are equally versed in how they work. You might want to run the names of your available lenders through HUD’s database search page.

As for the principal amount, you need to keep the rehab portion below that $35,000 threshold — or $50,000 in an OZ — but you have to take out at least $5,000. Including the acquisition price of the property itself, the cap varies between $331,760 in low-cost counties and $765,600 in high-cost counties, NerdWallet reports. (OZs tend to be low-cost.) Your loan amount can’t exceed 110% of the project, according to The Balance.

Pluses and minuses

There are, then, plenty of reasons to go the 203(k) route, but it’s not without its potholes.

On the positive side, you need to put down only 3.5% of combined purchase and repair costs, and there doesn’t appear to be any restrictions on how you came up with the money. Also, your FICO score can be as low as 580 and you could still qualify. (At least for the mortgage insurance. Your lender might have other ideas.) Under the right circumstances, you can refinance a bridge loan with 203(k) funds or use them to pay the rent in temporary quarters while the project proceeds. While 203(k) interest rates are usually a percentage point higher than other FHA loans, they’re still below private-sector market rates.

Still, there are strings attached — beyond the loan value increase only applying to OZs. First, this isn’t intended for DIYers; you have to get receipts from contractors. Funds are then held in escrow until they’re distributed directly to those contractors. Not only that, you have to get bids from multiple vendors before you can finalize the deal with FHA, and they have to be licensed, insured full-timers. It’s best if those bids are computed on a cost-plus basis because an appraiser has to sign off on it and it’ll be an obvious red flag if a bid looks like a SWAG.

Also, and this pretty much goes without saying when you’re dealing with Washington, it generally takes longer to close than if you were dealing with a private mortgage insurer, and involves a ton more paperwork. So make sure your lender has experience with 203(k) loans and is willing to walk both you and FHA through the process.

Also, you don’t have complete autonomy over what modifications you can make. FHA is a stickler for taking care of health-and-safety remediation — mold, lead, asbestos, termite damage, broken windows, missing banisters — first. After that, you can see if there’s any money left over to remodel bathrooms, install appliances, paint, lay carpet or improve energy efficiency.

The 203(k) program’s “limited” or “streamlined” loans specifically exclude structural repairs — you’d need to find some other source to fund those — although it permits replacing the roof. Structural repairs are allowed under a “standard” 203(k) loan, but there are restrictions that apply under either version, but these are at least partially subject to interpretation. “Major” landscaping is permitted but “minor” isn’t. Such “luxury” amenities as tennis courts are forbidden but you can fully trick out a kitchen; there’s a whole lot of gray in the middle. But whatever you do, the project has to be completed within six months.

Oh, and you can’t buy furniture. All fixtures have to be permanent.

And that includes you. The 203(k) program is specifically not intended for fix-and-flip. That said, guidance is sort of loose-goosey in this regard. It’s expected that you’ll be moving in yourself. Once you’ve done that, though, you can move out after a year. Also, if you’re buying a multi-family building, there’s nothing stopping you from renting out another unit or two or three. While co-ops are not allowed, 203(k) rules do permit condos under certain circumstances, according to Zillow. Also, as Holly Johnson at LendingTree reports, the property can be mixed-use, as long as at least 51% of the structure is residential.

One more helpful hint: For those who can undertake a project under the auspices of a not-for-profit organization, there’s a carve-out for that.

If you want to rehab a property and aren’t sure you can paint inside these lines, you might consider Fannie Mae’s HomeStyle program or other FHA options.

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