Upstate Buyer: Buying a fixer upper? A construction loan could be the answer
The cabin, which over the summer of 2019 will morph into Blue Quill Cottage. Follow the progress at @bluequillcabin or on Facebook.
I write this still giddy with excitement at my own real estate purchase a week ago, and am looking forward to using my upcoming experiences with the renovation and grounds improvement as a way to provide insight to prospective, or even current, homeowners about how stuff works…or doesn’t. This rustic cabin will undergo a pretty rigorous transformation, becoming “Blue Quill Cottage”. But today focuses on the first question I had to answer when I knew I wanted the cabin: What’s my financial approach to undertaking home purchase AND a gut renovation? There are more options than just scraping together the cash for the construction work.
I’ve known the last two owners of the pictured cabin because it’s a few doors down from my own house, and I sold it for the first to the current. When those folks asked me to list it for sale, I snapped it up myself (sorry to those who realize that would have been their dream purchase).
But I also knew the history and state of the house, more or less. It’s a “seasonal cabin” which is a euphemism for little or no heat (in this case none), little or no insulation (ditto) and therefore water pipes that would freeze in winter, rendering the house unusable during freezing temps. What I’d forgotten was that instead of a breaker box, that orderly set of two columns of switches in a metal box on the wall, this has old fashioned screw-in fuses. Many of you may never have seen this set up before, but what it means is that that thing is OLD! The words “fire hazard” come to mind, and with it, the realization that the whole house needs to be rewired.
Rewiring a house unleashes a Pandora’s box, because while you have all the walls open, you might as well tackle a host of other items, which I’ll address another time. The key upshot is that it makes sense to bring the cabin up to present-day code and style, for year-round use, which would include, of course, using it as a vacation rental through my sister company Red Cottage Inc.
WHAT IS A CONSTRUCTION LOAN?
The short answer is that there are many variations and structures possible with a construction loan. It can be a stand alone loan for a build or reno, where funds are released as work is completed. In my case, it’s essentially two loans in one. The first is the construction portion, ie financing the renovation, and the second is the mortgage, but with one set of closing costs, so there is a savings.
For the most part I’m going to use real numbers, but I may adjust some for simplicity sake. I agreed a purchase price of $165,00 directly with the sellers. I called my key vendors: Contractor (no chance I’m sharing his name until he’s done!), foam insulation guy, electrician, plumbing & heating people and kitchen people, and got estimates from each (that can take time, by the way, because we all know how hard it is to have calls returned, etc. so this is not a swift process). I estimated other key components and essentially asked for an $80k loan, which would bring the total investment to $245,000. The amount you have to put down will often be a percentage of the FINAL loan amount, so keep that in mind.
Old-fashioned round fuses = potential fire hazard. Not a great day when you see those during your house tour.
Then it’s up to the bank to determine if they think the property will appraise at $245,000 once the reno is complete. They want to know they can sell it for that price in the event of a default. Now obviously I’m a real estate broker, and I had sold two not dissimilar houses in my sparsely populated town in the last twelve months and I know this market. And yet, the bank appraisal came up short. I will not go into my opinion of the flaws in that appraisal (like choosing a “comparable” house in Pine Bush, a town so distant I’ve never been there), but it just goes to show that some things are out of your control. My choices were to pony up the shortfall in cash, reduce the financed amount, or ask for an override that still loaned on the original request. Clearly I took the latter.
The process now that we've closed the sale is that as we hit certain milestones along the road to completing the renovation. The bank releases chunks of that $80k, reimbursing me for payments I will have already made to the tradespeople. Interest only is charged on those disbursements until the project is complete, at which point the loan is rolled into a mortgage, when monthly principal and interest payments are charged.
For my mortgage structure I opted for a 7/1 ARM. An “ARM” is an adjustable rate mortgage, and the 7/1 represents that the interest rate will be fixed for the first seven years, and will then adjust every “1” year based on changes to a recognized index. With these structures, homebuyers enjoy a lower initial rate as a “reward” for taking on the risk that after seven years interest rates could increase substantially.
If you are among the intrepid few who are willing to tackle a gut renovation, or even if you just want to learn more about how a house is put together (and disassembled!), stay tuned as I embark on my own project taking a seasonal cabin along the headwaters of the Neversink River and upgrade it to year round status, while adding, hopefully, a bit of flair. I’ll document the project here in the blog, but you can also follow @bluequillcabin on Instagram and on Facebook.