Understanding FHA 203(k) Program: Part Two
Process, Procedures and Best Practices
Second in my series to help real estate agents and consumers understand the opportunities that are available in considering renovation or customization of a home at the time of purchase or as an alternative to selling in the first place. Many, many people think that custom construction is a arena of real estate that is only available to the very wealthy.....the FHA 203(k) program is available to anyone from the first time home buyer to the CEO of a major corporation. The program is open to anyone who qualifies for a traditional FHA loan and provides many more options above either finding the "perfect" home or "settling" for the "almost perfect" home.
The very first step in determining the advantages or disadvantages of working with the FHA 203(k) program should be a honest evaluation of whether you, as a real estate agent or a consumer, are a good "candidate" for the experience. This evaluation has absolutely nothing to do with the financing requirements, the property or the renovation process. It does, however, have very much to do with personality and adaptability to change and flexibility in temperament.
Explaining and counseling real estate agents and consumers through the process is not difficult as long as all parties understand, from the very onset, the importance of attention to detail and complete and through communication between all parties involved in the transaction. That said, I would suggest a meeting of the minds PRIOR to even considering using a FHA 203(k) program. There are simply people who are not psychologically equipped (whether agent or consumer) to deal with the process of renovation and construction. Word to the wise: "Know thyself".
Having issued my "caveat" let the fun begin! I am, and always have been, a certified "Project Freak"...I love the process of creating a masterpiece from the ashes. Move a wall, add a room, raise a roof or update a kitchen.....these are all enjoyable past times for me and I offer my experience and passion for the process to help agent and consumer alike in uncovering the possibilities within the walls of a structure.
Process, Procedure and Best Practices
Financing a FHA 203(k) loan, on average, will take 45 days from the time of initial application to the successful closing of escrow. It is important to understand that the closing of escrow marks the start of the renovation. Again, setting proper expectation is crucial. The program allows for up to six months of escrowed (impounded) loan payments to ensure enough time to complete the renovation and improvement of the home.
Step one: Application for financing.
Time Frame: One to three hours
The application process is very similar to traditional FHA financing, with the exception of the counseling process and instruction/implementation of the "next steps" of looking for and consulting with licensed contractors. Expect to provide all income and asset verifications at the time of initial consultation. Like traditional FHA financing, the consumer will need a minimum of 3.5% down payment (gifts acceptable) and assets must be verified at application.
Step two: Meeting with the FHA counselor.
Time Frame: One to four hours, scheduled at the time of application and conducted within 48 hours of application. Report due within 5 to 7 days.
The role of the FHA counselor is crucial to the process and lays the foundation for the success of the renovation. The counselor (inspector) is usually a licensed home inspector or appraiser and his/her role is to meet with borrowers at the property to determine 1). Condition of subject property, 2). Necessary health, safety or system improvements and 3). Determine the goals and ambitions of the borrowers.
Following the initial meeting, the FHA counselor will prepare a specific work order and cost analysis of the necessary and proposed improvements to be included in the loan package. The report is very detailed and will give a line by line explanation of the complete renovation project.
The cost of the FHA counselor varies between $400 and $1000, depending upon renovation/remodeling costs (< $7,500 and > $100,000, respectively). This cost is generally paid upfront, but can be reimbursed through the close of escrow.
BEST PRACTICE: Providing prospective and bidding general contractors with a copy of the FHA counselor's report (MINUS estimated figures) will expedite the bidding process greatly. FHA standards require the bidding process to "mirror" the counselors report. General contractors are likely to prepare a bid of "Remodel Kitchen: XX dollars"...providing them a copy of the line by line itemization of the FHA counselors report streamlines the process considerably. It also goes a long way in identifying price gorging or unrealistic under bidding by the contractor.
NOTE: The choice and selection of the General Contractor cannot be diminished in the successful implementation of the 203(k) program. This is the one area of the program that necessitates complete control of process and flow throughout the close of escrow and after wards, through the renovation draws.
Step Three: Interviewing and selecting licensed General Contractor and procuring bids
Time Frame: Entirely dependent upon borrower and contractor motivation and time constraints.
CAUTION: This is the one area that can completely blow the process and time frames for the proper execution of a specified close of escrow. Consumers need to "OWN" this as the lender and investor (or agent or loan officer) are not going to "direct" them to one contractor or another. The program requires the contractor to be licensed, insured and bonded...outside of that the consumer MUST do their due diligence to ensure they are working with a reputable and efficient contractor.
The completeness of the plans and specifications of the remodel/renovation are required for submission to underwriting (and they must conform to local, state and federal building codes to ensure building permits for the project).
BEST PRACTICE: There are a number of things an agent and loan officer can do to provide the home buying public on how to shop for and interview a general contractor. This is part of the consultative nature of this product, but crucial to the project is the consumers understanding that they are very much in control (or, for that matter, out of control) of this aspect of the loan process.
NOTE: The 203(k) program provides for up to five "draws" throughout the construction process. With the exception of special order item deposits, the program does not permit any prepayment for services to be rendered by either General Contractor or his/her sub-contractors. While many contractors prefer to be paid as much as one-third "up front", this issue can usually be worked through once the contractor completely understands that ALL construction funds are fully escrowed and there is NO chance they will not be paid for their services.
The 203(k) program mandates that an escrow contingency fund between 10% and 20% be held in reserve throughout the process to ensure coverage of unexpected or chosen changes to the project.
Step Four: The Appraisal Process
Time Frame: Five to seven days
The most unique aspect of the FHA 203K program is the fact that there are essentially two appraisals on the subject property. First the appraiser will determine "initial value" to determine a base line of the value as the property is at the time of contract. Secondly, the appraiser is provided a copy of the FHA counselor's report and the accepted General Contractor's bid to work up an analysis of the "future value" of the property.
The final figures on the "future value" of the home will set the actual loan amount for submission to underwriting. Of course, it is imperative that the loan officer has pre-approved the borrower for a loan amount at, or above, the "future value" in the first place.
The cost of the appraisal process is generally going to be around 50% higher than a traditional appraisal, and this fee is also paid on an upfront basis.
NOTE: To be discussed further in the Part Three: Marketing the 203K, however, it bears noting here that this is also where the opportunity lies for consumers who are slightly underwater on a under improved property to refinance and remodel to bring the property value up to a marketable and profitable condition.
Step Five: Processing, Underwriting and Conditions
The processing, underwriting and conditional process of this program is no different than any other FHA product (at least at my company. There is no need to send the loan package to the investor for additional approval and sign off........NOTE: I would not recommend working with any company that needed secondary sign off).
The borrowers' loan file is very similar to a traditional FHA loan, the importance is in the detail of the FHA counselor report, the contractor bids and the appraisal process. It is imperative that these steps and processes mirror each other in detail and cost analysis/value.
Step Six: Close of Escrow, and the Beginning of Renovation
Once conditions are cleared, docs are ordered and buyers/sellers (or homeowners) have signed loan documents are signed funds are disbursed to the sellers and/or their lender per normal and traditional procedures. In the case of a refinance, the underlying lender(s) will be paid in through escrow.
Following the actual closing, the process of the implementation of the FHA 203(k) will actually "begin".
Step Seven: The Construction/Renovation Process
There are several points throughout the process that agents/consumers/contractors/loan officers need to be monitoring the "behind the scenes" activities. For example, the selection of a General Contractor and getting bids for the project are "behind the scenes" of the actual loan process, however, can severely impact the process flow of the loan.
All permits must be pulled to begin the construction process and all "draws" of funds are based upon completion of certain aspects of the project (depending upon the scope of the work). The FHA consultant, as well as local building inspectors, will provide as the stop gap, or quality control agent, for the project. Funds will not be released until sign off by both the FHA counselor and local building inspector.
Step Eight: Changes and contingencies
As noted previously, the 203(k) program requires a specified amount of monies set aside for any unexpected events or changes in the project costs. As anyone who has ever embarked on a home improvement project will attest, things rarely progress exactly as planned. There are unexpected events (like issues with wiring behind the sheetrock that the FHA counselor could not see at the time of inspection) and there are "Oh, I changed my mind" events when one realizes that the initial plan is not exactly what they want.
The "draw period" of the 203(k) program allows for changes and contingencies (whether unexpected or planned) by allowing submission of a work order addendum throughout the process. Generally, here is a 24 hour approval process to the work order change, but the process is fairly simple and should not impede completion of the project.
Additionally, the borrower has the option of rolling any unused funds in the 10% to 20% contingency fund into the loan to reduce the principle balance at the time of the final draw on the project and/or submitting a final work change order to add further improvement to the property (landscaping, for instance).
The flexibility of the 203(k) program provides an opportunity for consumers to customize their home to their specifications without the high cost of custom construction and is a product that can help many agents and consumers in today's market.