A rehab loan, commonly known as an FHA construction loan, is a finance option to buy an upper-fixer home or renovate one. Instead, it is a technical name for a simple mortgage type precisely for purchasing the house itself or doing some structural advancements. The most common type of rehab loan is the FHA 203k loan. These loans are backed explicitly by the Federal Housing Authority to ensure the credibility and strategies are on point and reliable enough for buyers to make the process as fluent as possible.
How does a rehab loan work?
What is a rehab loan?
As mentioned earlier, rehab loans are just a rather technical name for a simple and easy mortgage. The process is as simple and general as a standard housing loan. But there are some key differences and significant factors that you need to know. For a rehab loan to work, you need to follow some guidelines as instructed by HUD.
The Preparation
Applying for a loan is very easy if you follow the proper guidelines. Look for the house in the neighborhood you want to rehab. Talk to a licensed contractor and make reliable estimates of the work it requires. This work will include the materials, labor, and other overheads necessary for the job. Even if you have approval for FHA 203k, you need to retake approval after making reliable estimates. Shake hands with a professional finance person or banker to handle this job for you. To get a better offer in the market, the buyer takes bids from various contractors and closes the loan on the one he/she finds fit. After the proposal, the lender and the buyer receive a copy of this bid.
The Application
FHA orders an appraisal to evaluate the future value of the home after the house renovation. A list of documents, including all relevant information related to the contract, is submitted in the underwriting, including bid, appraisal, credit and asset disclosures, and the buyer’s income sources. On specific terms and conditions, the underwriter approved the loan, and the finances are issued. Half of the loan is released instantly, making good equity available upfront, and 50% of the contract release after the work. After the loan is closed, the result deems to complete in six months. After the contractor’s completion, the contractor gets the remaining amount, and the buyer has one figure with one discount rate to unfold in upcoming years by paying it all up.
How do you qualify for a rehab loan?
It is most likely to qualify for FHA 203k if you have previously approved an FHA mortgage loan. There are some conditions and requirements to follow to be eligible for a rehab loan. Let’s have a brief look at the requirements.
1. Credit score
The higher the credit score, the better are the chances to get a 203k loan approved. The minimum credit score starts from 580, but there is a particular preference allotted to the buyers holding over 720 credit scores. So the FICO credit score will make you an easy route to qualify for your rehab loan.
2. Advance payment
An advance payment follows a rehab loan, much like other mortgages of similar natures. This advance payment or down payment can be as low as 3.5%. But bear in mind that the down payment you pay upfront is inversely related to the mortgage insurance and the monthly installments. If you have a 30-year loan or more, you can relieve your mortgage insurance by paying a 5% or more down payment. Similarly, for a rehab loan of term 15 years or more, a downpayment of 10% should be enough to get you some relief from the mortgage insurance.
In any case, you cannot or don’t want to pay such a high down payment, and you have to carry mortgage insurance on your back for the term of the original rehab loan. For most of the typical loan holders, for a 30-year term loan with a 3.5% down payment, you will have to pay a mortgage insurance premium of 0.85%.
3. Debt to income ratio
FHA assigns a specific limit for your debt to income ratio. That is, your income should not be more than 31% of the total revenue. This 31% includes the insurance premiums and any tax applicable. Any other loan, including the rehab loan, should not be more than 43% of your total income.
But this is not the final statement, and some lenders may go beyond these criteria.
4. Property valuation
Property supported by rehab loan should have enough appraisal to invest the loan amount. If the loan amount is $50,000, the home should qualify for this amount after all work. The FHA does this valuation by property inspection. This inspection covers the value in monetary terms and evaluates if it is safe to live and falls into the quality life standards.
What credit score do I need for a rehab loan?
The minimum credit score for an FHA 203k loan is 580. But the chances to qualify for a rehab loan are directly related to the credit score. Some lenders may also allow the rehab loan with a credit score as low as 500, but it is rare and not favorable. Furthermore, if you have a credit score lower than 580, you have to pay a high down payment of 10%. If you have a credit score of more than 580, the down payment reduces to 3.5%. Isn’t it worth the trade-off?
Can a first-time home buyer get a rehab loan?
The government backs a rehab loan for the sole purpose of easing the general public with below-market interest rates. Rehab loans are available for first-time homebuyers, not only for buyers but also for those who want to renovate their house, falling in the guidelines and requirements of a rehab loan.
The Bottom Line
A rehab loan has some guidelines to fulfill. But if your case covers these points, you can apply for a rehab loan. It can be two in one as if you have the loan for buying a home, and it also holds some portion for renovating the existing house. So, now you know why it is called a rehab loan.
