Fix-and-flip real estate investing provides an excellent opportunity to generate short-term profits. The idea is to find a house listed at a discount due to its condition, then renovate and repair the property before fliping it for a profit.
While there are plenty of challenges that you’ll encounter when investing in fixer-uppers, one of the biggest ones is trying to obtain the money to fund the required renovations.
After all, most investors won’t have the requisite cash on hand to pay for the work out of pocket. Fortunately, there are many financing options to consider.
What You Need To Start Financing For Your Renovation
While there are a lot of loans out there to fund your renovations, there are a few things that you should do before you begin speaking with lenders.
The following are a couple of essential things that you will need to consider before looking for home renovation financing:
Your Current Credit Score
Your credit score will be reviewed by a potential lender, so make sure it’s in good.0 standing before applying for any loans. The higher your credit is, the better your loan terms will end up being.
If your credit score is low, it will indicate to lenders that there’s a greater risk that you might default on your loan. As a result, your loan terms may be much harsher, or you may not even qualify at all.
If you have a poor (or even average) credit score, you may want to consider improving it before you decide to apply for a home renovation loan.
You can do this by prioritizing the following:
- Pay down your debts: Pay down your existing debts (especially credit card debts). Doing so will help lower your credit utilization score (ideally, it should be under 30%).
- Make on-time payments: Make all of your monthly payments on time. Not only does this help with your credit score, but it will also look good on your credit report.
- Avoid opening new lines of credit: Don’t open new lines of credit in the months leading up to your loan application. Lenders will be worried that you’re taking on additional debt so soon before attempting to take out a loan.
How Much Do You Need?
Before you apply for home renovation financing through a lender, make sure that you know exactly how much money your project will cost. If you borrow less than you end up needing, then you won’t be able to finish renovations.
This may mean you won’t be able to flip the house within your projected timeframe, and you could find yourself in a tricky financial situation as loan payments pile up.
You also need to figure out what kind of home renovation loan terms (including interest rates and fees) are available to ensure that the home renovations won’t adversely affect your finances down the road.
Moreover, don’t borrow more than you can realistically afford to pay for (including home renovation costs and home loan repayments), or it could affect your ability to make money once the real estate is sold.
While there are loans out there that will let you borrow up to 100% of the home renovations, these loans usually come with high interest rates.
As a result, it’s generally a good idea to only borrow what you need for the home renovations. Doing so will help keep your costs down and make it easier to repay the loan once the home is sold.
The Loan To Value Ratio
Home renovation lenders will take into account your loan-to-value (LTV) ratio when considering you for a loan. The LTV ratio will give them an idea of how much equity you have in the property. The more equity you have in the home, the better the loan terms will be. Lenders risk less when they lend money to someone with a high LTV ratio.
If you don’t have much equity, or if you’re using the home as collateral for the loan, you’ll likely need to pay for private mortgage insurance (PMI), which will increase your home renovation costs.
Loan Options Available To You
Now that you know what you need to do before you can apply for a home renovation loan, it’s time to go over some of the financing options that are available to you for your fix-and-flip real estate investment. The following are the various home loans that you can apply for to help cover your renovation costs:
Mortgage Refinance
Refinancing is a process in which you replace your first loan with a second loan. There are several reasons that you might want to do this.
For example, suppose your initial loan had high interest rates, and you now qualify for lower rates.
In that case, a mortgage refinance can save you money on your interest, thereby lowering your monthly repayments. You can then put the money you save every month towards the cost of renovations.
The Benefits Of A Mortgage Refinance
The following are a few advantages of getting a mortgage refinance to pay for renovations:
- You can get a new home loan with better terms, including a lower interest rate and no fees.
- You can use the money you save every month for the renovations on the property.
- You can consolidate your debts, or even combine multiple mortgages into one.
The Disadvantages Of A Mortgage Refinance
There are a couple of disadvantages to consider if you’re thinking about getting a mortgage refinance, including:
- You will have to pay closing costs to refinance your loan, which can be expensive.
- There’s no guarantee that you’ll qualify for lower interest rates. If your rate was already low to begin with it might not be worth the trouble.
- The amount you save every month may not be enough to cover your renovation costs.
Home Remodel Or Home Repair Loan
Some lenders offer loans specifically for renovations and repairs. Lenders who do offer such loans generally use the after renovation value (ARV) to calculate how much you can borrow.
As a result, you may be able to qualify for a large loan based on the potential profit that you might earn.
The Benefits Of Home Remodel Or Home Repair Loans
The following are some of the significant benefits of taking out a home remodel or home repair loan:
- The amount you can borrow is dependent on the ARV, which means you’re more likely to qualify for the amount you need to pay for your property’s renovations.
- If you’re a real estate investor with good credit, it can be easier to qualify for a home remodel loan since lenders know that you’re using it to flip a house and generate a profit.
- The interest rate on a home remodel loan tends to be lower than other types of loans.
- You will likely be able to write off your interest payments.
The Disadvantages Of Home Remodel Or Home Repair Loans
The following are a few cons of trying to take out a home remodel or home repair loan:
- Home remodel and home repair loans aren’t as common as you might think. It can be difficult to find a lender that offers them.
- It can take longer to process a home remodel loan. A lot of paperwork is involved, and calculating the ARV is a process in itself.
Home Equity Line Of Credit (HELOC)
A Home Equity Line of Credit (HELOC) is a line of credit that lets you borrow money against the home’s equity. Instead of borrowing all of your home improvement costs at once in a lump sum like with other types of home renovation loans, you’ll be given a line of credit from which you can withdraw funds as you need them.
Since HELOCs are revolving loans, you only need to pay back the interest on the amount that you withdraw from your HELOC at any given time. If you’re not sure how much money you’ll need for your home renovations, or if you’re making numerous renovations over a longer period, this can be pretty helpful.
The Benefits Of A HELOC
The following are the benefits of using a HELOC to pay for renovations:
- Interest rates are lower than other loan options. Investors with good credit could qualify for loans with interest rates below 5%.
- If you’re using the funds for home improvements, you may be able to deduct the interest payments from your taxes.
- They’re perfect for long-term renovation projects since they allow you to withdraw only what you need.
- You only pay interest on the money that you withdraw.
- Once you pay down what you owe, it goes back into your line of credit, which means you can withdraw it again.
The Disadvantages Of A HELOC
The following are the disadvantages of using a HELOC:
- You will have to use the house as collateral. As a result, if you don’t pay back what you withdraw from the HELOC, you could lose your investment if the property is forced into foreclosure.
- The interest rate is variable, which means that even if you start with a favorable rate, it could increase over time (depending on the market).
- The amount you can access in your HELOC will depend on the LTV ratio as well as your credit score.
Cash-Out Refinance
A cash-out refinance isn’t dissimilar to a regular mortgage refinance. However, you can take out more than what you owe on the property, which means you can use the difference to pay for the renovations.
Say the property is worth $300,000, and you have $150,000 in equity (meaning, you still owe $150,000 on your initial mortgage). You can refinance the $150,000 balance for $200,000, giving you $50,000 in cash that you can use on renovations.
The Advantages Of A Cash-Out Refinance
The following are the pros of applying for a cash-out refinance:
- If you have a lot of equity, you can secure a large loan to cover the renovation costs.
- Refinance loans tend to have lower interest rates than other types of loans, such as HELOC or home equity loans.
- If you use the loan for renovations, you may qualify for mortgage interest tax deductions.
The Disadvantages Of A Cash-Out Refinance
The following are some of the cons of a cash-out refinance:
- You’ll have to pay closing costs, which can amount to 2% to 5% of the loan.
- If you take out a loan that’s more than 80% of the home’s value, you’ll be required to pay mortgage insurance.
- To secure a cash-out refinance, you’ll have to use the property as collateral, which means there’s a risk of foreclosure if you are unable to make payments.
Credit Cards
Using a credit card isn’t out of the question, especially if you don’t have the credit score needed to secure a more traditional home renovation loan. The ability to use a credit card for your renovations depends on your credit limit and the expected cost of renovations. After all, credit card limits are rarely as substantial as the amount you could obtain through a loan.
The Benefits Of Using A Credit Card
The following are a few benefits of using a credit card:
- It’s much easier to use a credit card you already have or to open up a new credit card than it is to secure a large loan.
- You only pay interest on your card’s balance. You might be able to qualify for a zero percent introductory interest rate if you open up a new credit card.
- Loans often come with closing costs, credit cards do not.
- You won’t have to put your home equity up as collateral.
The Disadvantages Of Using Credit Cards
The following are a few cons to keep in mind when considering the use of a credit card for home renovations:
- Credit card interest rates are very high. Credit card interest rates vary based on the credit card company, but they typically range from 13% to 19%.
- There’s no deadline for paying off your balance. While this can be a benefit, it can also be a drawback: the longer you go without paying off the balance, the more interest you’ll accumulate and ultimately end up paying.
- Credit cards are only suitable for smaller renovations. If large renovations are required, a credit card likely won’t cover the costs since most credit cards don’t have large limits. The last thing you want to do is take out five credit cards and max them all out to pay for renovations as this could jeopardize you and your finances.
- Carrying too high of a balance can hurt your credit score, making it more difficult to take out loans should you decide you need additional financing to cover your renovation costs.
- Some contractors may not accept credit cards for certain jobs.
Government Loans
Some government-backed loans are available for home improvement projects, such as the Federal Housing Administration (FHA) 203(k) Rehab Loan, the Freddie Mac CHOICERenovation loan, and the Fannie Mae HomeStyle Renovation Mortgage.
These loans are great if you’re looking to invest in fix-and-flips since they allow you to roll the cost of the property and the cost of the renovations into one loan.
The Benefits Of A Government-Backed Renovation Loan
The following are the benefits of using a government-backed renovation loan for your remodeling project:
- Down payment requirements for your investment property are very low–you may be required to put down as little as 3.5%.
- Interest rates are usually lower than conventional loan rates.
- Financing is based on the ARV of the investment property and not its initial purchase cost, which means you can secure a bigger loan to cover the renovations needed.
- Because these loans are government-backed, credit score requirements are lower than conventional loans.
The Disadvantages Of A Government-Backed Renovation Loan
The following are some of the potential drawbacks of using a government-backed renovation loan:
- Some government-backed loans, such as the FHA 203(k), require an upfront mortgage insurance fee.
- Some government-backed loans, such as the HomeStyle Renovation loan, use conforming loan limits. If the amount you need exceeds the limit, the interest rate will be higher.
- Some government-backed rehab loans require you to live in the house, which can be tricky as an investor.
Personal Loans
A personal loan is a loan that is provided in one lump sum. Personal loans are available as either secured and unsecured loans, which means that no collateral is required. Most personal loans are unsecured.
If you don’t want to put your house up as collateral, a personal loan can be a great option to finance your renovations. However, it will be challenging to qualify for an unsecured loan if your credit score is low.
The Benefits Of A Personal Loan
The following are some of the pros of using a personal loan to pay for your renovations:
- You won’t have to pay closing costs.
- You won’t be required to put your house up as collateral.
- You can secure the loan quickly (often in a matter of days).
- Depending on your credit, you may be able to secure a large amount if you need financing for large-scale renovations.
The Disadvantages Of A Personal Loan
The following are the cons of taking out a personal loan for your renovations:
- Interest rates can be quite high, especially if your credit score isn’t great.
- You will have to pay off the personal loan by a pre-established date.
- Fees and penalties can be very steep if you miss payment dates.
- Depending on the lender, you will have to pay loan origination fees of 1% to 8%.
Paying With Cash
If you have cash on hand, whether it’s in your checking account or your savings account, then that’s always an option when it comes to paying for renovations. Once you finish renovating the house and flip it, you can return the profits back to the account from which you withdrew your funds.
The Benefits Of Paying With Cash
The following are some of the advantages of paying for your renovations using your cash:
- It’s the cheapest option for paying for renovations since you won’t have to pay any fees, fines, or interest.
- You don’t have to deal with a significant amount of paperwork.
- You won’t have to worry about your credit score.
- Since fix-and-flip investments are short-term, you won’t have to go long without getting your money back.
The Disadvantages Of Paying With Cash
Although it might seem like a no-brainer to pay with cash if you can, there are a few drawbacks to consider before you choose to do so:
- Using your own cash can limit your financial flexibility, unless you have large reserves. If you’re using everything you have to pay for renovations, you could find yourself in a bind if you are suddenly faced with a financial emergency.
- The money you’re using could be better served in a retirement account or invested elsewhere. You may be better off taking out a loan even if you do have the cash reserves.
- If your investment goes poorly, you immediately risk losing a lot of your own money.
Hard Money Loans
Last, but not least, there’s the hard money loan (also referred to as a short-term bridge loan). Hard money loans are popular among real estate investors because of their short turnaround time.
In fact, investors typically use hard money loans specifically for fix-and-flip real estate. Lenders require the property to be used as collateral, and the terms are generally short-term, meaning you’ll have to pay it back right away.
The Benefits Of A Hard Money Loan
The following are some of the reasons to consider taking out a hard money loan:
- Private lenders can approve a hard money loan in a very short period of time. The quick turnaround means that you don’t have to wait very long to begin work on your property’s renovations.
- You can secure as much as the property is worth to use for your renovations.
- Terms are flexible. Because the lender is private, you can potentially renegotiate your terms at some point. If you build a relationship with the lender, they’ll be more likely to approve hard money loans at more favorable terms in the future if you pay your first loan off on time and in full.
- Because your property is collateral, credit score requirements tend to be lower.
The Disadvantages Of A Hard Money Loan
Keep these disadvantages in mind when considering hard money loans:
- The term length is generally very short. If you can’t pay the loan back within a year or two, you could be in trouble.
- Because term lengths are short, monthly payments tend to be bigger than conventional loans.
- Interest rates can be very high–above 10% isn’t out of the ordinary.
- You have to put your property up as collateral, which means you could lose it to foreclosure if you fail to pay back the loan.
Finance Your Renovation Wisely
As you can see, you have many options for financing your renovations. Be sure to compare all of the available loan options and be aware of the risks associated with each type of loan. Different types of loans have various pros and cons, so be sure to weigh them all when deciding which route to take for your investment property.