The FHA 203(k) program is the loan program to assist you with repairing/ rehabilitating your primary residence. In other posts we’ve discussed improvements that are required, eligible improvements and improvements that are ineligible for the loan program.
By now you have selected your property. You have determined you offer price for the property, as is. Or perhaps you are repairing/ rehabbing your existing home.
You have been working with your real estate professionals to determine your cost estimates for your project. You are meeting with your lender and she tells you we must include a contingency reserve.
What is a contingency reserve, you ask? The contingency reserve is used to cover any extra work not included in the original proposal.
There may be some cases where HUD does not mandate a contingency reserve, but plan on your lender requiring a reserve. HUD’s rules do state that for properties over 30 years old and estimates over $7,500, the cost estimate must include a contingency reserve. HUD goes on to state at the mortgagee’s discretion a contingency reserve may be set up. Trust me, plan on including a contingency reserve.
The contingency reserve must be a minimum of 10% of the cost of rehabilitation. If the utilities were not turned on for the inspection, a minimum of 15% is required. The reserve may not exceed 20% of the cost of rehabilitation where major remodeling is contemplated.
I have found that the concept of a contingency reserve requirement can be confusing. Quite simply, this is established to cover unforeseen expenditures and is for the benefit of everyone involved in the project. Why is that, you ask?
Let’s say, for example, your estimate for rehabilitation costs is $50,000.00. The project begins and somewhere along the way it is discovered that it is really going to costs an additional $5,000.00. Without a contingency reserve what are you going to do?
· Are you going to pay this out of your own funds? You may not have it available
· Are your contractors going to say, just pay me later when you can? Don’t count on it
· Is your lender going to say, it’s ok the project has not been completed? Absolutely not!
· Are you going to be happy the project is unfinished? You know not.
A 15% contingency reserve established and added to your $50,000.00 cost estimate would provide $57,500.00 to cover rehabilitation costs. The $5,000.00 additional cost is covered from the loan proceeds drawing from the contingency reserve.
- You are happy the project is completed without draining additional resources being drained.
- Your contractors are happy, they are getting paid
- Your lender is pleased the project is completed
- You are admiring what you have accomplished, and how well your new home looks and how functional it is.
The key point is, your loan documents must provide for these unforeseen costs. The loan documents are 
drawn for a specific amount and that amount can not be exceeded. Without a contingency reserve you could be stuck. Any unspent funds, from your loan proceeds, after the final work item payment is made, must be applied to the mortgage principal. In other words, you will not be making payments on funds you did not use to repair/rehab you home. For the example we have used your loan balance is reduced by $2,500.00. ($7,500 contingency reserve less the $5,000 in unforeseen additional costs)
I hope this and other posts will be helpful as you prepare to utilize FHA’s 203(k) program.
As always, I welcome comments. What has been your experience with the 203(k) program? Do you have any questions? What observations or opinions do you have toward this financing vehicle?
Tip for real estate agents and contractors: review listed properties needing repair/rehabilitation; develop the estimates for work to be done; partner with a knowledgeable and trusted lender familiar with the FHA 203(k) program; have a turnkey project list to share with prospective buyers
Coming Soon
Specification of Repairs/Work Write Up
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Jay Williams
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