Comparing two mortgage options for a property that needs renovations
If you're buying a house that needs some love, you've got some work to do. Whatever you're planning - updating the kitchen cabinets, replacing the roof, adding a master suite - it's going to take a bite out of your wallet. So before you run out to buy that first gallon of paint, take some time to consider a couple of home loan options that can help you get the job done. In this blog, we'll compare two popular mortgages: a conventional loan and the FHA 203(k) - a renovation loan that can help you finance remodeling and renovation projects.
So what's the difference?
A conventional mortgage is a traditional home loan used to purchase a property. Conventional loans are popular because they typically offer the best interest rates and loan terms resulting in a lower monthly payment. To qualify for a conventional loan, you'll need to have a higher credit score and debt that is no more than 43 - 50% of your gross monthly income. Your down payment can be as low as 5%.
You can certainly buy a fixer-upper with a conventional loan, and many people do, but you'll still need a plan on how you'll finance the renovations. For example, you might already have the cash on hand, have plans to take out another loan or are thinking about using a credit card or two. If you take out another loan on top of your conventional mortgage, you may be looking at a home equity line of credit - HELOC - which acts as a second mortgage. That means, in addition to your monthly mortgage payment, you'll be paying this monthly bill as well (along with a different interest rate, terms and due date).
In comparison, an FHA 203(k) loan may give you more peace of mind for one simple reason: you don't need to worry how you'll get the extra cash to fund your renovation project. This loan type allows you to combine both the purchase and renovation of the property into one long-term, fixed-rate mortgage. The total mortgage amount is based on the projected value of the property after repairs have been completed, including labor costs. Once you qualify, you can choose between two loan options: A limited 203(k) that finances repairs for up to $35,000, or the standard 203(k) for repairs of more than $35,000.
The down payment
With a conventional mortgage, as long as you put 20% down, you can avoid paying private mortgage insurance (PMI). Or, if you don't have that kind of cash, you may qualify for a conventional loan with a down payment as low as 5%. Just keep in mind that if you're putting less than 20% down, you'll be required to pay PMI until you've reached 20% equity in your home.
One of the benefits of the 203(k) loan is its low down payment option of 3.5%. For example, you can expect to pay $5,250 on a $150,000 home (includes purchase price plus renovation costs). In exchange for the low down payment option and flexible lending requirements, there's just one caveat - you'll be required to pay mortgage insurance.
Mortgage insurance adds a significant upfront and ongoing monthly cost to the FHA loan compared to conventional, yet because of the reduced down payment option, the 203(k) is by far the most common popular renovation loan. Also, keep in mind that once you've completed your major renovation project, it's likely you'll have increased the value of the house by more than what you spent on the work. And, once you reach 20% equity (you have to wait a year before the current value can be used for a new home loan), you have the option of refinancing to a conventional loan which will not require mortgage insurance.
Where you can live
With a conventional loan, you can buy a primary residence, vacation home, or investment property. FHA loans are limited to owner-occupied properties, which can include multi-unit properties as long as you live in one of the units.
Who's doing the work?
As a homebuyer or home owner, the 203(k) loan lets you finance a contractor to do the work. In fact, it's a requirement for almost all of the work involved. So, if you'd rather pay a pro to build and remodel, then you'd likely consider the 203(k). If you'd rather put the time and effort in yourself for a little "sweat equity," then you'll want to find an alternative to the 203(k) loan - like a conventional mortgage.
Conventional or FHA 203(k) comparison
|Down payment||Minimum 5%||Minimum 3.5%|
|Mortgage insurance||Required if less than 20% down||Yes, along with small ongoing monthly fee|
|Credit score requirements||Higher||Lower|
|Seller contributes to closing costs||9% if putting 20% down||6%|
|Down payment assistance||Yes||Yes|
|Gift funds for down payment||Yes||Yes|
|Uses||Primary, second homes and investment properties||Primary home only|
Your current financial situation can help determine whether a conventional or 203(k) loan is right for you. It's always a smart idea to talk to a mortgage consultant who has experience with 203(k) loans, and can help you explore your loan options and focus on helping you reach your goals.*
You're closer than you might think to buying a home. Download our Loan Options Guide to explore the possibilities.
*Amerifirst Home Mortgage is one of the top twenty FHA 203(k) providers in the nation, as ranked by the Department of Housing & Urban Development (2019).