As a real estate investor, there are many financing options that you can pursue, whether you’re buying fix-and-flip properties or rental properties. If the property you’re looking at requires renovations and repairs, then one type of financing that you might want to consider for your investment is a renovation loan.
Renovation loans can benefit investors, however, they aren’t for everyone. Read this article to learn more about renovation loans, the pros and cons, and what to know before applying for one.
What Is A Renovation Loan?
A renovation loan is a type of loan that helps borrowers cover the cost of repairing or renovating properties in various states of disrepair. They are useful because you can use them to cover both the property cost and the repairs and renovations.
Because renovation loans cover both the property and the required renovation costs, lenders base the loan amount on the after-repair value (ARV). The ARV of the property determines how much you can ultimately borrow using a renovation loan. The ARV represents the property’s value after you’ve made the repairs and renovations.
How Do Renovation Loans Work?
Renovation loans work a little differently than other types of loans (such as mortgages). First, renovation loan lenders require an appraisal of the property to determine the estimated ARV. The investor can then apply for a loan that covers the purchase price of the property along with the cost of any repairs or renovations.
If you are approved for the loan, you can go ahead with your project. However, you won’t receive the entire sum upfront. Generally speaking, you’ll get the amount needed to cover the purchase price of the property upfront. But the part of the loan provided to cover the renovations and repairs will be held in escrow and released in installments as the work is completed.
Renovation Loan Types And Where To Get Them
It’s important to understand that not all renovation loans are the same. There are several different types of renovation loans that are available. The following are some of the commonly available home renovation loans to consider:
Investor’s Line Of Credit
An investor’s line of credit provides you with a certain amount of money in the form of a credit line that you can withdraw from as needed. A line of credit differs from a traditional loan, which provides the entire loan amount upfront.One benefit is that you only pay interest on the money you withdraw.
Additionally, you can withdraw funds as often as you need, up to the maximum amount. The money you pay back will go right back into your line of credit, and you can withdraw from it again as needed. You can use your line of credit for whatever you want, which means you can invest it back into multiple properties if desired.
However, the amount in an investor’s line of credit depends on the equity you have in a property. Therefore, you can’t apply for a line of credit if you don’t have any equity. A line of credit can be helpful if you already own the property (or you own other properties) and need financing for renovations and repairs.
But if you need funding for the purchase of a property, then you’ll likely need to look elsewhere unless you have a significant amount of equity in one or more of your other properties.
Fannie Mae HomeStyle
Fannie Mae is a government-sponsored agency, which means that all loans from Fannie Mae are backed by the government. Fannie Mae offers a few different home loans, but the HomeStyle loan is a single-close loan specifically designed for people looking to buy and renovate properties.
A single-close loan refers to the fact that there is only one loan, as opposed to a more traditional mortgage where you would get a loan for the purchase price of the property and then a second loan for the repairs and renovations.
One benefit of the HomeStyle loan is that it can be used on both investment and owner-occupied properties. Loan terms are also available for 15- and 30-year lengths. However, there is a borrowing limit of 75% on the ARV of the property you’re buying and renovating.
Although HomeStyle renovation loans are available to both primary homebuyers and investors for various property types, investors will have to pay a bigger down payment. As an investor, you’ll have to put down 15% to purchase a property or 25% to refinance. You’ll also need a credit score of at least 620 and a debt-to-income ratio of less than 50%.
Single-Close Construction To Permanent Loan
A single-close construction is a construction loan used to cover the costs of renovations on a property. It’s essentially a type of cash-out refinance loan that replaces your existing mortgage based on the ARV of your property.
The portion of the loan for the renovations is paid directly to the contractor instead of the homeowner. Disbursements (which are a series of payments from a fund held by the lender) are made to the contractor using a milestone-based disbursement schedule. Banks that offer these loans require regular on-site inspections for distributions to occur.
One of the benefits of this type of loan is that you won’t have to take out two separate loans, and you’ll only have to pay closing costs once. In addition to being able to spread payments over a 30-year term, interest rates tend to be low as well. Finally, investors who need a substantial amount can borrow over $1 million using a single-close construction loan.
However, there are a few drawbacks. Firstly, although credit score limits vary based on the lender, many lenders require higher credit scores (from 680 to 720) to qualify.
Additionally, because you’re basically refinancing an existing mortgage, you’ll need to pay both the standard closing costs and the costs associated with a typical construction loan. There’s also a chance you’re refinancing at a higher rate to access renovation funding.
Finally, it’s worth noting that contractors may not want to work on the project due to the regular on-site inspections required for disbursements.
Two-Close Construction To Permanent Loan
A two-close construction to permanent loan is similar to a single-close loan but, as the name suggests, two loans are involved instead of just one. These loans are usually used by investors or homebuyers that are building their property from scratch.
In general, the first loan closing is used to secure interim construction financing, which provides the necessary funding to buy a lot of land and start construction on the property. The second loan closing is then used to secure permanent financing once all construction is finished. This second loan closing is completed in the form of a refinance.
Because there are two loans involved, you can shop around and secure better rates than you may have been able to with a single-close construction loan. However, there’s more risk involved since you need to be approved twice for two separate closings.
In addition, because there are two closings, it will also take longer to get approved, and you’ll have to pay closing fees twice.
EZ “C” (Conventional) Renovation Loan
The EZ “C” loan is a conventional loan that is specifically designed for people looking to finance renovations and repairs that can be completed within 60 days. The cost of the renovations or repairs is rolled into the loan that was used to finance the house.
The part of the loan to be used on renovations and repairs is then placed into an escrow account. After that, the lender handles payments directly to the contractor. It’s important to note that EZ “C” loans are meant for cosmetic renovations, so you can’t use them for structural improvements.
Additionally, the improvements you make must add value to the property. These types of loans are perfect for minor renovations, such as installing new cabinets in the kitchen. There’s a $35,000 limit (or 10% of the ARV) on the costs of renovations that the loan can cover and you will need to put a down payment of 5% of the combined value of the property.
The conforming loan limit on properties is currently at $647,200. If your ARV exceeds this number and you need a loan that includes both the cost of the property and the renovations, then you’ll need a jumbo renovation loan.
A jumbo renovation loan works like an EZ “C” loan, except that it’s used for higher-priced homes. Like an EZ “C” loan, the renovations you make using a jumbo renovation loan must add value to the property but cannot be structural changes.
Another option is simply going to your bank and applying for a renovation loan. The application process for a bank loan is similar to a traditional mortgage, however, the approval process is stricter because banks tend to view investors as a higher risk than homeowners.
For instance, credit score requirements for a bank loan will be more rigid than normal. This means that if you’re buying an investment property, you’ll need a higher credit score to qualify than you would if you were buying a home. Additionally, higher credit scores will be needed to secure better terms.
Private Lender Renovation Loans
Private lenders can include anyone from a family member to an investment group. Although private lenders often charge higher interest rates, they are typically more willing to work with you if you want to finance a fixer-upper.
As such, a private lender renovation loan can be easier to qualify for, and also tend to go through quicker, which means you can get the money you need for your investment project faster.
Advantages Of Renovation Loans
Now that you have a good idea of what a renovation loan is and the types available, you’ll want to know the benefits of taking one out. The following are some of the primary advantages of getting a renovation loan for your investment property:
- Lets Investors Buy Properties For Less Than Market Value
One of the best strategies for finding properties that are available for less than the market price is to look for distressed properties. Distressed properties are properties in need of repairs and renovations. Because they aren’t in perfect condition, they are often available at a substantial discount.
Getting a traditional loan for a house in bad shape can be difficult, however renovation loans are made exactly for this purpose. They provide you with the money needed to buy and renovate a property. Once you remodel the property, you can flip it for a profit or find a tenant to earn regular rental income.
- Most Loan Terms Are Flexible
Most loans have strict terms, however this is not the case with renovation loans. The terms of these loans are typically much more flexible than those of traditional loans, especially if you get a renovation loan through a private lender. Private lenders are more willing to be flexible if you have experience with investing and can demonstrate that the investment is a good one.
As such, the lender can create a loan that is more favorable to you. In addition, once you have an established relationship with the lender, they may provide you with even more favorable terms in the future.
- Can Be Used To Customize The Property
Another benefit of renovation loans is that you can use them to customize properties to your liking. For example, when you buy an investment property, it likely won’t be in the exact condition you want it to be in. You may want to build an extra bedroom or bathroom, or you may want to update the kitchen or flooring.
The great thing about a renovation loan is that you aren’t limited to using it for necessary repairs only. You can use it for all types of renovations, including updates. Whatever the case, a renovation loan will allow you to make these changes and customize the property so that it’s more appealing to buyers or renters.
Although there are several benefits to using a renovation loan for an investment property, no loan is perfect. Renovation loans also have their share of disadvantages that you’ll need to be aware of. These include the following:
- Requires Top-Notch Credit And A Stable Income
You’ll need excellent credit and a stable income to qualify for a renovation loan. If you don’t have both of these things, it won’t be easy to qualify for the loan because most lenders want to ensure that you are a low-risk borrower and can make your loan payments.
A property that requires extensive repairs is often considered too big of a risk for lenders because it requires an even greater investment to fix it up — and there’s no guarantee that you’ll make a profit after repairs have been made.
Additionally, the risk increases if the borrower has poor credit or can’t prove they’ll be able to make their loan payments on time and in full. It means there’s a greater chance of the borrower defaulting on the loan, which could result in the lender losing money in the long run.
- Some Loans Require Approval From An Appraiser
Some loans require an appraiser to approve the estimated value of the property in its current state, in addition to its ARV.
This requirement can be a problem if the investment opportunity requires a lot of repairs and the appraiser doesn’t think the property will be worth the investment once you make the repairs. It can also be an issue if you need to act fast because other bidders are waiting to buy the property.
- Most Loans Require Approved Construction Plans
If you are planning on making significant repairs or renovations to the property, most lenders will require that you have approved construction plans in place before they’ll fund the loan. This requirement can be challenging if you’re unsure what repairs you need to make or how much the repairs will cost.
You’ll also need to find reliable contractors who can give accurate estimates of the work required, and you may need to do a bit of research to compare estimates between different contractors. Unfortunately, all of this can take time, hindering your ability to take advantage of an investment opportunity that requires fast action.
Do You Need Real Estate Experience For A Renovation Loan?
Generally speaking, it helps to have previous real estate investment experience. However, not having real estate experience won’t automatically disqualify you. You may be able to secure a renovation loan if you have excellent credit, a stable job, and proof that the investment is a sound one.
However, it can still be challenging to find a lender willing to take a risk on a renovation loan that covers the cost of a distressed property and all the required repairs.
It’s much easier to secure a renovation loan with real estate investment experience. It gives lenders peace of mind knowing that you understand the risks and rewards of investing in real estate. Plus, if you have a proven track record of success in flipping properties, it will be easier to convince a lender that the next property you’re interested in is a wise investment.
Additionally, previous real estate investment experience can go a long way towards securing a renovation loan if you don’t have great credit or a stable income.
Home Projects Covered By This Loan
Renovation loans can cover a wide range of repairs and renovations. However, most lenders will want to view and sign off on your plans for the property. After all, they want to ensure you’re not wasting your funds on unnecessary additions that won’t improve the property’s value (such as swimming pools).
Keeping that in mind, the following are some of the home projects that most home renovation loans will cover:
- Upgrading/replacing plumbing, heating, and cooling systems
- Insulating homes for energy efficiency
- Replacing roofs and gutters
- Replacing windows
- Buying new appliances
- Major remodeling
- Room additions
- Adding a second floor
- Structural repairs
- Any project that takes over six months to complete
How Renovation Loans Differ From Other Home Loans
When it comes to funding renovations, there are a few other options. As such, it’s worth mentioning how a renovation loan differs from the following:
- Traditional Home Equity or HELOC Loans: A home equity loan and a home equity line of credit (HELOC) loan differ from renovation loans in that they are based on the equity you have in your primary home. An investor’s line of credit is somewhat similar in that it’s also based on the equity of a property.
However, an investor’s line of credit allows you to borrow against the equity in an investment property or even against your whole portfolio instead of just your primary home.
- Personal Loans And Credit Cards: You could take out a personal loan or use a credit card for the renovations on your investment property.
However, renovation loans are usually much bigger since they not only cover more expensive renovations, but they can also cover the entire cost of the property. Personal loans and credit cards have much lower limits, so they’re not as practical for this purpose. They also tend to come with much higher interest rates.
- Traditional Cash-Out Refinance: A conventional cash-out refinance will give you a lump sum of cash that you can use on the investment property in any way, including for renovations.
However, you’ll need good credit and a low loan-to-value (LTV) ratio to qualify. As such, you probably won’t be able to secure as much funding as you would with a renovation loan.
What To Consider Before Getting A Renovation Loan
Even if you’ve weighed the pros and cons of a renovation loan compared to other types of loans, there are still a few factors to consider. The following are some of the questions you should ask yourself before deciding to take out a renovation loan:
- Will the project increase the home’s value?
Consider whether you’re confident that the planned renovations will increase the value of your property. If not, you could end up selling the property at a loss compared to the amount of money you put into it. Not to mention that you’ll have wasted a significant amount of time.
- Will the repairs save you money?
In some cases, certain repairs on a property may not be worth the money invested as they won’t ultimately affect the ARV.
For example, if the windows are outdated and in disrepair, then you may want to consider replacing them altogether instead of wasting money fixing them. Fixing them may not affect the ARV at all but will cost you money to do, whereas upgrading them will add value to the house.
- Will you still make a profit?
Be careful about spending too much money on the repairs and renovations of your investment property. If these expenses are excessive, they could significantly cut into any expected profits.
If the original cost of the property and any expenses exceed the final sale value of the home, then you’ll make a loss. It’s therefore important to factor in the estimated ARV when planning any renovations.
- Are you in a rush to renovate?
If you’re planning on renovating as quickly as possible so you can flip the property right away, then a renovation loan might not be the best option.
After all, lenders will take their time to do their due diligence to ensure the investment is sound and that all the estimates are accurate. This can take some time to do. If you need money right away, you might want to consider an alternative, such as a hard money loan, which is not only approved faster, but also processed much quicker as well.
Factors That Can Affect The Loan Calculation Process
Many factors can affect the amount you need to borrow, from the price of the property to the type of renovations you’re planning. However, there are a few less obvious factors that you should take into consideration as well. With that in mind, the following are a few different factors that can affect the price and value of your home renovation project:
Local Zoning Regulations
You’ll want to consider the local zoning regulations before taking out a loan. Zoning regulations refer to the restrictions that a city or town places on the development and use of land.
In some cases, the rules may not allow for the type of renovation you’re planning on doing. For example, some local zoning regulations may not allow you to build an addition to the property you’re looking to invest in. Therefore, you must understand your local zoning regulations before making renovation plans, as they could affect your potential ARV.
Another thing to be aware of before taking out a renovation loan is that the lender will likely require a home inspection. Home inspections ensure that the property is in the condition you think it’s in.
If a home inspection reveals serious issues, it means that repairs may cost more than you anticipated. The last thing the lender wants to do is give you a loan for a property that needs more work than you were planning on doing.
For example, suppose the inspection reveals major damage that will cost tens of thousands of dollars to repair. If that’s the case, it could cut into the potential ARV of the property.
Of course, one of the most crucial things to consider before taking out a home renovation loan is the cost of repairs. After all, this is what you will use the loan for. Therefore, getting accurate estimates from contractors is essential.
The last thing you want to do is underestimate the cost of repairs. If you do so, your loan may not be big enough to cover all of your repair costs, putting your entire investment at risk.
You’ll need to make sure that you find a reputable professional to give you an accurate estimate. Unfortunately, less reputable contractors may give you a lower estimate in a bid to secure the job. As a result, you could end up having to pay for repairs out of pocket because your loan wasn’t big enough to cover the actual costs of repairs.
Price Breaks For Services
In some cases, you may be able to get a price break on the services you need for your renovation project. For example, if you’re planning on doing a lot of work yourself, you may be able to get a discount from the contractor.
In other cases, you may be able to negotiate a lower price for materials if you purchase them in bulk. You should explore every option before making your final decision, as you may be able to save yourself a lot of money in the long run.
Doing It Yourself Versus Choosing A Contractor
Finally, you need to decide whether to do the work yourself or hire a contractor. If you plan to do the work yourself, it’s important you have all the necessary skills and knowledge necessary to complete the project successfully.
Otherwise, you could end up having to hire someone to do the work anyways, costing you more in the long run. Not to mention, if you don’t have experience doing home renovations, it could take you longer to complete the project. The longer it takes to finish work, the more it will cost you.
Consider All Your Loan Alternatives
If you’re considering a home renovation loan, it’s essential to consider all your options. There are various loans available, and each has its own set of advantages and disadvantages. Therefore, it’s important to find the loan that best suits your needs, whether it’s a renovation loan or not.
Here at Pine Financial Group, we offer renovation financing solutions specifically for investors. You can use these financing solutions for many real estate investments, including fix-and-flip projects.