Fixer-Upper: Conventional Loan or Construction Loan?

If the house is a "fixer-upper" being sold as is, would you get a convetional loan or a construction loan?

3 Answers

That is a loaded question which depends on true property condition viewed by an appraiser and investor.  If you intend to place a large amount of improvements right away - I would suggest a construction loan.  If property is OK as is but you would like to fix here and there as time/monies allow - you could go conventional. 

The key determinationwould be an opinion of the appraiser on property condition /value and acceptance of condition/value by investor to allow the loan in "AS IS" property condition.  If value and condition are subject to major repairs that the seller won't spring for - you will most likely need a construction loan and then roll into permanent loan as repairs are completed. 

There are several factors to take into consideration when trying to finance a fixer-upper that is being sold as-is.  One aspect of the question will determine whether a regular loan (either conventional, portfolio or FHA) is even available.  Here's why:  in the course of attempting to obtain financing, the lender will obtain an appraisal in which the appraiser is required to state whether there are there any physical deficiencies or adverse conditions that affect the livability, soundness, or structural integrity of the property.  In the event that there are, it is very unlikely that any lender will make a plain-vanilla traditional loan.  To put it quite plainly, they won't take a borrower's word that such deficiencies or condtions will be repaired post-closing. 

Instead, they will require that some mechanism be put in place to ensure that those conditions and deficiencies are repaired.  That mechanism comes in the form of a construction loan in which the borrower submits specific plans for repairs, the lender approves those plans and the funds for the work are escrowed and distributed to the third-party in installments as the work progresses.  Similarly, the appraiser will be required to address whether the property is in poor, fair, average or above-average condition.  Again, if the property is in less than average condition, it is very unlikely that a lender will make a traditional loan.

Another thing to take into consideration is -- even if the property qualifies for a traditional loan -- the amount of cash or credit available to make post-purchase repairs.  Let's say you can get conventional financing with 5% down or FHA financing for 3.5% down and you have $20,000 in cash left over for repairs.  You might ask yourself whether you'd sleep better at night with a payment that was $100 a month higher if you financed the repairs (assuming for the sake of illustration a 5% interest rate) and kept the $20,000 in the bank or vice versa.

If the cost of the work is $35,000 or less, you can finance 96.5% of the combined cost of the purchase and repairs using the FHA Streamline 203(k) Limited Repair Mortgage.  You can read more about that type of loan in another Wiki answer I wrote for this site by following this link

When buying a fixer-upper, be sure to get a home inspection and once you do, get estimates from qualified contractors so that you know exactly what you're getting into.  That way you'll be able to make the most informed decision possible about the journey on which you're about to embark.  There's no question that construction loans are a bit more involved than a traditional loan.  In many cases, however, the extra effort is well worth it.

Another question that needs to be asked here is what are the nature of the repairs needed on this "fixer upper?"  A lender may not be willing to lend money on a conventional loan if the needed repairs pose a threat to health, safety, or saleability.  They may require some repairs to be done, typically by the seller, and show proof of the repairs before they will allow you to close on the home. 

Remember, banks think in terms of worst case.  In this case the worst case is that you do not make the repairs that you intend to make, find the house to be a money pit, walk away, and they end up foreclosing and trying to re-sell the house.  Now, your money pit becomes their money pit and in addition to the money they have lost on your loan they will probably be forced to finish the repairs before putting the property back on the market.  Would you lend your money on such a property? 

The alternative to this is going to be a construction loan where the bank knows that there is money and qualified contractors to complete the work.  Yes, they are typically going to require that you hire a contractor and not allow you to do all of the work yourself.  In some cases, like a 203K streamline, you can be the general contractor and just hire several subcontractors to do specific parts of the rehab.  There are exceptions to this, but you generally have to show a resume of construction experience or training that qualifies you to do the work. 

For example, they're not going to let you do any electrical or plumbing work unless you are qualified in those trades.  However, some programs may allow you to do some work such as installing flooring by just showing a certificate from one of the Saturday DIY classes from your local home improvement store or something really simple like painting.  Also keep in mind that there are construction time limits to complete all work, usually 3-6 months.  The lender will not allow the rehab project to continue indefinitely.  They want the work completed within a defined time frame.   

When you talk to a lender about these loan programs, you're probably going to be discussing either a FHA 203K rehab loan or a Fannie Mae Homestyle loan.  Not all lenders offer these and there are actually two different 203K programs, depending on the amount of work to be done and what kind of work.  There are some significant differences between the two 203K programs that I won't go into here.  You may have to talk to several lenders before you find someone that can do them.  I would also make sure that you find a lender that has experience in construction lending.  This is actually a fairly specialized area of mortgage lending and not all loan officers are going to understand the intricacies and requirements of what is a fairly complex loan product.