People often finance home repairs with cash-out refinance loans. These loans work similarly to other mortgage products except that lenders usually charge higher interest rates and impose tougher underwriting guidelines on these loans. However, if you have trouble financing your home repairs, the Federal Housing Administration offers a special rehab loan that many people use as an alternative to regular refinance loans.
Cash-out Refinance
When you take out a straight refinance loan, you use the loan proceeds to payoff an existing mortgage. On a cash-out refinance, you use some or all of the proceeds for another purpose, such as repairing your home. Lenders sell most refinance loans to government-sponsored Fannie Mae and Freddie Mac and these entities buy straight refinance loans on which the borrower can finance up to 95 percent of the property value. On cash-out refinance loans, these entities limit to loan-to-value ratio to 80 percent. Therefore, if you do not have a lot of equity in your home, you may not qualify for a cash-out refinance loan.
203(k) Loan
The FHA insures 203(k) rehab loans that you can obtain from lenders that partner with the FHA. You can use an FHA rehab loan to finance major repairs but you cannot use it to finance purely cosmetic changes, such as installing luxury upgrades. Unlike a regular refinance loan, the FHA bases your loan amount on the after-repair value rather than the current value. Furthermore, you can borrow up to 100 percent of the after-repair value of your home with a 203(k) loan. Lenders typically do not finance homes that need major renovations but you can use a 203(k) loan to finance a home that needs major structural repairs.
Drawbacks
The FHA insures lenders against borrower default and you have to pay for that insurance through monthly premium payments. Therefore, these insurance costs significantly add to the cost of the loan. Furthermore, you can only use a 203(k) loan to finance one-to-four unit family dwellings. However, you cannot finance a condominium if more than 25 percent of the units in the same complex are being financed with FHA loans. Furthermore, you can only finance owner-occupied condos. Additionally, many lenders do not offer these loans, so you may find it hard to obtain a 203(k) loan.
Alternatives
Cash-out refinance mortgages and 203(k) loans both involve significant closing costs. If you cannot afford to pay these upfront fees and lack the equity to roll the cost into your loan, you could finance your repairs with a home equity loan. These loans usually involve higher interest rates but lower closing costs than refinance mortgages. You could also finance the repairs by taking out a home equity line of credit in which case you just draw on funds as and when you need the money during the repair process. However, equity lines have variable interest rates so in the long-term your monthly payments could rise whereas you can get a fixed payment on a refinance or a 203(k) loan.
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