Expert: Lisa Webber - 11/4/2007

Question
I am buying my first home directly from the owner. We agreed on a purchase price of 700,000. Home needs about 50,000 spent on updates and improvements. Owner is willing to add that to the price so that we can get a higher mortgage and will reimburse that money to us for updates. What are the pros and cons of this kind of arrangement? Increasing the price may affect the city tax bill ? Please advise.

Thank you for your time.

Regards

anil

Answer
Please consult a real estate attorney as to the legality of this type of arrangement. I am not an attorney so I cannot give you legal advice. You'll want to disclose all of the details and make sure that what you are doing is legal in your state as well.

I will give you some things to consider on this transaction.

The house must appraise for the amount that you are purchasing it for if you are borrowing the money from a lender.

With a standard mortgage, you are only allowed to borrow money for the home as it is when you buy it. The reason for this is the house is the collateral for the loan. The mortgage company or any subsequent purchaser of the mortgage needs to be able to take back the house in case the payments are not made so they can re-sell the house and recoup their investment. Not that you will foreclose, this is just standard procedure to protect the lender. If you borrow money above the mortgage amount, that is unsecured and in case of default, the mortgage company will not be able to recover the extra money as the house will most likely not sell for enough. The house will need to appraise high enough in the as-is state as well.

This is the reason that in this market, it is very difficult, if not impossible to get 80/20 loans where you borrow 80% on the first mortgage and 20% on the second mortgage.  In some areas, homes are declining in market value and if they are foreclosed on, the first mortgage is paid first, then the second.  If the market value is lower than when the house was purchased, there will not be enough money to pay off the second mortgage.

Make sure to tell your lender exactly what you are trying to do so that the loan is done properly and legally.  

One way to be able to legally do a transaction like this is to get a "construction" loan.  First Mariner Mortgage has a construction loan available (I'm sure others do as well).  What happens with a construction loan is you are able to borrow the money for the house and in addition, you can borrow the money for the remodeling.  The process goes in stages.  First the lender sends out an appraiser to appraise the house.  They send out a contractor that is approved by the lender to write up an estimate for the amount of work that needs to be done.  If they feel that the value of the house will appraise at the total amount of the loans or higher, then they will approve the loan.  

First you'll settle on the initial mortgage.  Then the contractor will begin work, the lender will pay him in stages as the work progresses.  Then you'll settle on the rest of the loan after the work is completed. It ends up being only one loan, but you'll have two settlements.

Yes, the higher price may affect your taxes and will affect the settlement fees that are based on a percentage of the sales price.  

If you are getting a great price and the house appraises for much more than what you are paying, you can settle on the first mortgage, then get a home equity loan for your projects and complete them yourself as you would like.  With home equity loans, lenders in todays market will usually let you borrow up to 80% of the equity in your house. I have seen advertisements for no cost home equity loans; you may be able to do this without additional fees.

I hope this helps.  If you have any other questions or would like any clarification on anything I can answer, please let me know.  Good luck to you!