What Is a Conventional Rehab Loan and How Does It Work?
Explore conventional rehab loans, a streamlined way to finance both your home's purchase/refinance and its renovation costs.
A conventional rehab loan offers a financing solution for individuals looking to acquire or refinance a home while simultaneously funding its renovation. This type of mortgage integrates the cost of the property and the expenses associated with planned improvements into a single loan. It provides a streamlined approach, eliminating the need for multiple loans to cover both the purchase and subsequent home enhancements. This simplifies the financial process for borrowers aiming to transform a property.
Defining Conventional Rehab Loans
A conventional rehab loan, often called a renovation loan, combines the financing for a property’s acquisition or refinance with its renovation costs into one mortgage. Unlike government-backed options, such as FHA 203(k) or VA loans, these loans adhere to guidelines established by government-sponsored enterprises like Fannie Mae or Freddie Mac. Private lenders, including banks and mortgage companies, offer these products. This distinguishes them from standard mortgages, which only cover a home’s current value and require separate financing for repairs.
These loans are structured around the property’s anticipated value after renovations are complete, rather than its current “as-is” value. This allows borrowers to finance a higher amount, reflecting the improved home’s future worth. The primary conventional rehab loan programs are the Fannie Mae HomeStyle Renovation Loan and the Freddie Mac CHOICERenovation Loan.
Eligibility for Borrowers and Properties
To qualify for a conventional rehab loan, borrowers need to meet specific financial criteria. A credit score of at least 620 is typically required. Lenders also assess the borrower’s debt-to-income (DTI) ratio, which ideally should be below 45%. Borrowers must also demonstrate a stable employment history and have sufficient funds for a down payment.
Property eligibility extends to various residential types, including single-family homes, multi-unit properties up to four units, condominiums, and planned unit developments (PUDs). These loans can be used for primary residences, second homes, and in some cases, investment properties. The renovations must be permanently affixed to the property and are expected to add value. This includes a broad range of improvements, from structural repairs and energy efficiency upgrades to aesthetic enhancements and additions like a new bathroom or an in-ground swimming pool.
The Conventional Rehab Loan Process
Obtaining a conventional rehab loan involves several distinct steps once a borrower and property meet initial qualifications. The process begins with submitting a loan application. Borrowers must then engage qualified, licensed, and insured contractors to provide detailed bids and renovation plans for lender approval.
The appraisal process includes two valuations: the property’s current “as-is” value and its projected “after-improved” value. Lenders base the loan amount on this higher, after-improved value. Upon loan approval, a single closing takes place, combining the property acquisition and renovation financing. Funds for renovations are released in stages, known as draws, as work progresses and passes lender inspections. This ongoing oversight ensures the project adheres to approved plans and budget, culminating in a final inspection upon completion.
Key Characteristics
Conventional rehab loans feature several financial and structural elements. Loan limits are determined by the property’s “after-improved” value, subject to conforming loan limits established by Fannie Mae and Freddie Mac. Borrowers can often finance up to 95% of the property’s value after renovations. Down payment requirements can be as low as 3% to 5% for primary residences, though higher percentages may be required based on the loan-to-value (LTV) ratio and property type. If the down payment is less than 20%, private mortgage insurance (PMI) is typically required.
Interest rates for these loans can be fixed or adjustable, often offering more favorable terms than other renovation financing options like personal loans or credit cards. A contingency reserve, 10% to 20% of the renovation costs, is required to cover unforeseen expenses that may arise during the project. This reserve can be financed into the loan. Renovations are expected to be completed within 6 to 12 months from the loan closing. The single closing for both the mortgage and renovation funds streamlines the financing, resulting in one set of closing costs and a single monthly mortgage payment.