One of the biggest trends in the real estate market this year has been the amount of sales made up of distressed properties, that is, foreclosures and short sales. These properties are selling for a discount, and I’ve seen some amazing deals over the last year as borrowers buy homes for a fraction of the cost these homes would have sold for just a few years ago. There are some great bargains, but one of the problems with foreclosures (and to a lesser extent short sales) is that the condition of the home can make the property difficult to finance. Foreclosures often suffer from neglect, deferred maintenance and outright abuse. I don’t know how many homes there are in the Chicago area that sat through the winter with no heat and without being winterized, but I guarantee, the number would be big. This means there were a lot of homes this spring with water damage and mold. Add in all the homes which have other problems, maybe they need a new roof or furnace, or a rehab of the bathrooms or kitchen, or maybe they just need to be modernized. Whatever the problem, there are a lot of homes that either can’t be financed because of their condition, or they need work which you won’t be able to afford to do after you buy. The good thing is, there is a solution to this problem, the FHA 203K rehab loan.

The FHA 203K is designed so you include the cost of repairs and improvements into a purchase price and wrap it all into one loan. FHA divides the program into two sections, the full 203k and the FHA 203K streamline, or Mini K. The full program is for major projects and with this you can do anything from a major remodel to a full gut rehab. But the full 203K can be a complicated and expensive loan. You will need to hire an FHA 203K consultant to advise you and help with the paperwork, and getting it all done can be a big commitment. This is the right choice for big projects, but for most home buyers, the better choice is the FHA 203K Streamline.

The Streamline 203k is meant for more manageable projects, and the cap on spending is now set at $35,000. The reality is that you can get an awful lot accomplished with $35,000. I just closed on one loan where the new buyers finished their basement and added a bathroom, and it came in well under the spending limit. The Streamline 203K program is a great alternative because it makes the process simpler and with the scope of work more manageable, this means it is easier to close. This program also fits the reality of the market. Most of the properties out there don’t need gut rehabs, they need specific work done in order to be eligible for financing, or to improve the livability of the home. You can’t change anything structural with a Streamline 203k, but other than that you can tackle almost anything the budget allows.

Here is how the project works:

First step, get pre-approved for an FHA mortgage – This program is different in how it treats the property, but your credit approval will be the same as with any other FHA approval. This means a down payment of only 3.5% (based on the purchase price plus the repairs), credit scores of 620 and above, and all the other first time home buyer friendly features that FHA is known for. You need to know how much of a loan you can afford and how much cash you will need to close on the loan. One of the great features of FHA is it allows the seller to pay your closing costs (when negotiated in your contract, up to a max of 6%). Knowing how much cash you will need up-front helps when it comes time to structure your purchase in a way that works for you.

Find the house you want to buy – This sounds like the easy part, but that’s not always the case. If you are looking at distressed properties this means the bank that holds the mortgage has to approve the contract. This can take some time, and some banks are more responsive than others. Either way, when putting the contract together, make it subject to approval as an FHA 203K loan. Decide what work needs to be done, and get a rough idea of what it will cost.

Find a contractor that will do the work, and get the bid in writing – Getting the bid is the crucial step. You need a contractor who will put in a detailed bid showing exactly what work will be performed and with specifications and cost break downs for everything, including both materials and labor. We aren’t able to order the appraisal until the contractors order is in. The appraiser will use this bid to determine what work will be done, and what the value of the home will be once all the work is completed. Along with the bid, we will need to approve the contractor, this means your contractor will need to furnish us with a package showing his business licenses, a resume showing similar work done, and proof of insurance.

Get the appraisal – This is the biggest difference between an FHA 203k and a normal FHA mortgage. We order the appraisal through one of our FHA approved appraisers. They are actually doing two appraisals at the same time. The first part of the appraisal is based on what the property’s value is now, in its present condition. The second part values the property as it will be once all the work has been completed. The appraiser will take the detailed contractor bid and incorporate this into the appraisal. After the close, the work will have to be completed as laid out in the appraisal.

Underwriting and closing – Once we have the full file with the completed appraisal, the loan is underwritten like any other FHA loan. There is more paperwork on our end, and we need to make sure that everything conforms to the guidelines and all the pieces of the puzzle fit right. Once we have a clear to close approval, the loan is ready to close. The closing of a 203K is similar to any other closing. One thing to keep in mind, though, is you won’t get the money for the rehab at the closing.

After the close – It takes around 30 days before the loan is set up in the system. At this point you will get a check, made out to you and the contractor (or each contractor if you are using more than one) for half of the rehab amount. This is to cover the materials and to get the work started. You will also get a check list which tells you exactly what needs to be done from that point on. Once the work is completed an inspector comes in to confirm that everything was done according to the original bid, and once you have the sign off you get the rest of the money to pay the final bills. If the work comes in under the budget, the balance will be used as a principal pay down on your loan. All the work has to be completed within 6 months.

The FHA 203k rehab loan is a great way to take a rough home that you can buy for a bargain price, and turn it into a finished gem. This loan is a way that many buyers are using to add value to their home and gain instant equity. This is obviously a simplified rundown for the FHA 203k and if you don’t do things exactly right, there are a lot of little obstacles that can trip you up. But if you have a good experienced loan officer as your guide, the process is easier than you might think, and the best way to improve a home while keeping your investment and payments low.

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