We always hear that human beings are using less than 10% of their brain power, and if we could tap into the other 90%, the possibilities would be limitless. Look it up though and most scientists would say that assertion is a myth.

When it comes to our jobs, we rarely utilize all of the tools at our disposal. That’s a hypothesis that’s hard to argue with, and we’re not just talking about technology. If we use all of the tools at our disposal, the possibilities just might be immeasurable.

Last month we made an appointment with a client who was thinking of listing his home. He only bought it a year prior, and he had grand plans to renovate the place a little at a time. But after an unexpected career change, he never got around to the updates he had in mind and the place became a bit of a burden.

We knew that if we took the listing, not all of the potential buyers would be able to see past the dated décor and envision the potential within the home. So, we talked with the homeowner about marketing his property as-is, but also, simultaneously marketing it as what it could be. It was in a great location and had a ton of upside.

We could show renderings of an updated kitchen and living room. Perhaps more importantly, we could provide material that would explain to potential buyers that they could use a renovation loan to purchase the home and also pay for all of the renovations. And, we could show real numbers to demonstrate that the out-of-pocket costs wouldn’t be astronomically different compared to buying the property as-is.

Donna Attili at Citizens Bank told us, “Most people think a renovation loan is only done through a refinance or by adding a 2nd lien mortgage to a home they already own. But a renovation loan is also an amazing tool to use when you’re trying to unlock hidden potential or untapped equity in a home you’d like to buy.”

The unique aspect about a renovation loan compared to a standard mortgage is that a borrower’s loan amount is based on the “after-improved” value rather than its current market value. For example, Attili said that Citizens would lend up to 80% of what a home would be worth after all upgrades were made, even up to 90% at lower price points.

In other words, someone could purchase a property as-is for $1 Million and borrow $800,000 on a regular mortgage. Or, using a renovation loan, they could buy the same property for $1 Million, make $500,000 in renovations and borrow 80% of $1.5 Million ($1.2MM), assuming the value of the property increases by at least as much as the cost of the renovation.

Jonathan Miller, President and CEO of Miller Samuel, Inc. cautioned that not every renovation project is created equal. “There is no firm relationship with renovation cost and their ‘contributory value’, A.K.A what their cost to implement adds or detracts from the value of the overall property, because it can cut both ways,” Miller said. “The relationship between cost and contributory value can vary from one market to another because the “rule of thumb” for the cost/value relationship is that there is no “rule of thumb.”

Miller recalled a scenario in which a seller spent $50,000 on a purple Formica entertainment cabinet that he bolted to the wall of the living room. The seller added $50,000 to what they thought was fair market value. However, the eventual buyer estimated that it would cost $2,500 to remove the cabinet and deducted that amount from what they thought was fair market value.

A typical renovation loan allows for a huge variety of upgrades, including completely updated kitchens, new roofs, new appliances, and even new septic systems for homes outside the city. The loan process takes slightly longer than a regular mortgage, but the closing occurs before any of the work is done, so there is no real impact upon the seller. At the closing, eighty percent of the renovation costs are placed in escrow and disbursed by the lender in installments as the work gets completed.

There are some instances in which a buyer can almost immediately increase the market value of their new home by more than the cost of the renovations.

“Absolutely,” Miller said. “When observing a market and a particular type of renovation commonly occurs, it is largely because the renovation provided additional value to the property beyond the cost.  There was an economic incentive to do the renovation.”

The more we thought about a renovation loan, the more intrigued we became. It’s a tool that could potentially help any of our clients, sellers or buyers.

Like the example we provided in this article, it can be a part of an alternative way to market a property for our sellers. And for our buyers, a method for polishing a diamond in the rough, or a way to avoid liquidating their own assets to fund a major renovation on a new purchase.

We even run into situations where properties are considered uninhabitable or at least unmarketable because it’s in a state of disrepair or vital utilities aren’t working. Banks typically won’t offer a regular mortgage against properties like that. A renovation loan is the perfect lending product for situations like these – and that’s good for buyer and seller.

There are a few drawbacks though.

The rates for a renovation loan tend to be at lease a bit higher, .25% – .5% more in most instances compared to a regular mortgage. There are also additional closing costs, although not extremely prohibitive.

The process does take a bit longer, and the bank will send an inspector to the property several times during the reno to ensure that progress is being made before they’ll send out disbursements.

Most lenders won’t allow you to do any of the work on your own. In fact, very few lenders will allow a family member to do the work. They’ll want you to hire a licensed and insured contractor to complete the project.

Timing a renovation loan can be tricky because the lender needs plans and specs or architectural drawings before they can approve a loan — Mostly because the appraiser needs to know exactly what will be in place once all the work is complete — Otherwise, they wouldn’t have a way to gauge what the after-improved value would be. Quickly obtaining architectural plans for a property that’s listed for sale and is owned by another party requires careful planning.

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