You may have found your dream house, but once you pay the closing costs and escrow, you may not have enough cash left to furnish the place and make it feel like home. If your lender allowed you to borrow a little more than the asking price, your problems would be solved. However, such loans are hard to come by unless you plan to buy a home that needs major repairs.
Loan to Value
When you take out a mortgage, your house serves as collateral for the debt, which means your lender can sell it if you prove unwilling or unable to make your monthly payments. However, the foreclosure process involves legal and administrative costs -- and these deplete the proceeds from the sale of your home. Also, home prices can fall over the course of time, so the foreclosure sale could leave your lender with less money than you currently owe. To protect against losses stemming from foreclosures, lenders cap the loan-to-value ratios on loans. Depending on the property type, you can normally only finance between 75 and 95 percent of the purchase price.
During the housing boom in the 1990s, many investment firms realized that some homeowners needed additional cash after they had bought their homes. These investment firms began offering negative equity loans with lender-to-value caps of up to 125 percent. The lenders took the view that home prices would keep rising and this would reduce the likelihood of losses in the event of foreclosure. The housing market crash that began in 2007 caused most lenders to re-examine the whole topic of negative equity lending. In theory, you could find a lender willing to offer you such a loan today, but it isn't likely.
FHA Rehab Loans
While negative equity loans are few and far between, the Federal Housing Administration insures co-called fixer-upper loans. You can use one of the FHA's 203k loans to finance the purchase of a one- to four- unit single family home that needs repairs. The FHA defines necessary repairs as removing environmental hazards, painting, replacing the roof, making energy efficient upgrades and similar actions. You cannot qualify for an FHA 203k loan if you plan to use it simply to install luxury upgrades such as a hot tub or granite kitchen counters. The loan amount can exceed the purchase price because the FHA bases the loan amount on the after-improvements value of the home. Overall, you can borrow up to 110 percent of the home's current value with one of these loans.
FHA 203k loans are designed to help municipal governments rejuvenate cities by enticing people to buy existing homes rather than building new properties. While the loan-to-value guidelines sound quite attractive, these loans have other costs. The FHA insures your lender against losses stemming from a loan default and you fund this insurance with an upfront premium and monthly insurance payments. You must also prove to the FHA that you have enough cash in reserve to cover six months of mortgage payments. Depending on the cost of the home, you may or may not come out ahead by applying for a 203k loan instead of using your cash towards the home purchase.