Hazards of financing fixer-uppers

By William Kugel

With inventories low, rapidly rising prices, and affordable housing harder to find every day, many would be homeowners entertain buying a "fixer-upper" as a way of satisfying their drive to own a home at a price they can afford. The appeal is understandable. They hope to capture a diamond in the rough and through their own ingenuity and "sweat equity" turn the neighborhood dump into a crown jewel. Sometimes it is a couple's only way to bring to life their dream of owning their first home. Sometimes it is the challenge of restoring an eyesore to a pride of ownership property. Whatever the motivations, many prospective buyers are unaware of the difficulties involved in obtaining financing for their fixer-upper bargains. The first-time buyer is especially vulnerable when buying a fixer-upper. There are several potential pitfalls in attempting to borrow money against properties that have apparent physical inadequacies. If you're interested in buying such properties, here are some points to remember: The first principle to understand is that the property is the lender's security and as such they generally want only security that is readily marketable. Mortgage lenders get concerned that properties with structural or even cosmetic impediments that will hinder their salability in the event of a foreclosure. Fixer-uppers, from a lender's point of view, generally have inherent one or more of these impediments: a decrease in property value, a structural deficiency or hazard with a cost to correct, a significantly impaired ability to market the property promptly, or an impairment to occupancy for reasons of safety or health. Consequently, you can possibly expect to need written estimates and evidence of completion prior to closing on your loan. Occupancy issues include certification that bathrooms and kitchens are functional. When a loan application is evaluated, both the buyer and the property are underwritten. In general, the typical conventional mortgage offered by today's institutional lender, is intended for properties in average or better than average condition. When an underwriter is evaluating a property they are considering lending on, they must take note of and investigate any fair or poor ratings they find on the appraisal or they may not be doing their due diligence. The appraisal and the offer to purchase are two of the first places an underwriter finds clues to physical inadequacies. The actual and effective age as indicated by an appraiser may alert the underwriter to look at the property more closely. While guidelines vary from lender to lender, properties 25 years old (and older) will trigger closer scrutiny by a lender. If an appraiser suggests, recommends, or makes the appraised value subject to a termite or any other type of property inspection, the lender will almost automatically require and review those reports as well. Two more items that will draw an underwriter's attention will be any references by the appraiser to deferred maintenance or actual photos of the property that reflect poorly on its condition. Every loan package requires a copy of the purchase agreement. Underwriters examine the terms of the purchase contract between buyer and seller for clues to physical inadequacies. As a general rule, if the parties mention any serious or structural repair in their offer, the lender may need to investigate further. They will pay close attention the dollar amounts of needed repairs that ultimately diminish the market value of the property. On the other hand, if both the appraisal and the purchase contract are free of hints to possible deficiencies in the property, there are some lenders who have no requirements to ask for a structural pest control report or investigate the property further. Any substantial monies allocated by the seller to the buyers for subsequent repairs will usually be interpreted as a discount to the sales price. If the buyer is financing with a specific amount of money down (i.e. 10 percent down is 90 percent financing), a discounted sales price can seriously reduce the amount financed by the buyers. Substantial repairs must usually be dealt with prior to closing on the purchase money financing. Most lenders have no provisions for "holdbacks" and the few that allow it require more that the actual the amount held back (i.e. 150 percent). Work must be contracted for and completed in very short time frame. Many lenders have been burnt in the past and are no longer willing to trust the buyer to make the repairs later. When you do find a lender that will work with you on your fixer upper purchase, here are some things to be prepared for: 1. Have extra cash. Lenders will qualify harder on your cash reserves when a fixer-upper is involved.2. Put a little more money down. Lenders have less risk when you put down more money. The amount down can possibly influence their decision. Less than 20 percent down triggers mortgage insurance and their stricter underwriting guidelines.3. Don't overestimate what you can borrow. Most first mortgage lenders will not lend on the future value of the property, but on its "as is" condition at the time of closing. Otherwise, you may be backed into a corner needing a construction or home improvement loan requiring additional time and expense. However, ask your local lender about some of the new rehabilitation loans that incorporate home improvement and purchase loans into one step.4. Point out special skills or experience in a cover letter. Lenders may look favorably upon trade skills that can be utilized on the property for small repairs. Generally, it is better to present proposals from experienced contractors.5. Choose your loan program VERY carefully. A general rule of thumb: the smaller the down payment, the more important the condition of the property becomes. FHA, which offers one of the lowest down payment scenarios, will not accept fixer uppers unless you go into their rehabilitation program.6. Marginal buyers together with marginal properties don't mix. Unfortunately, it is often the first time buyer or a marginally qualified buyer that most desires a fixer upper property. Finally, I offer a few last suggestions. First, start pursuing the financing of your fixer-upper before actually making an offer. Be very cautious about making any offer until you are very sure about your financing. Get yourselves pre-approved. The time to educate yourself is before, not after, you've entered into a contract. Also, leave yourself an escape or contingency clauses in the event that you're unable to find a lender or have to compromise on the kind of terms that are prudent for your circumstances or the inspections indicate that the repairs are more than you expected. William Kugel is author of the column MORTGAGE$ in publication for 11 years, a senior loan officer with GMAC Mortgage Corp., and a Mount Washington Valley resident. You may write him c/o of The Conway Daily Sun, visit the web site www.gmacm.net/william_kugel or send e-mail to william_kugel@gmacm.com.All Rights Reserved. Copyright 2002, W.H. Kugel.