A contingency reserve on a renovation loan helps protect the homeowner and bank from additional construction costs that were not accounted for in the initial bid due to hidden issues.
A Contingency Reserve is used to cover cost overruns and is required on both FHA 203k Rehab Loan Programs.
The Contingency Reserve may range from 10% – 20% of the project
budget, depending on what the HUD consultant recommends. The
underwriter ultimately makes the final decision, unless the FHA 203k
guidelines state specific requirements for unique scenarios. For
example, vacant properties without utilities require at least 15% for a
Leftover funds in the Contingency Reserve can be allocated towards other projects of the Full 203k, and health and safety related upgrades on the Limited 203k. Otherwise, remaining funds that are part of the loan amount are used to pay down the principal.
With any of the FHA203K programs, you have a contingency reserve. The contingency reserve is a reserve that is there in case of cost overruns. This reserve can go anywhere from 10% to 20%. The typical amount that we see is usually about 10%. It really comes down to what the FHA203K consultant determines is going to be the contingency reserve. Now, he may say that the contingency reserve is 10%, but the underwriter makes the final decision, so depending upon what the consultant says, the underwriter will take that into consideration and then the underwriter will make the final determination. If the property is a vacant property and the utilities are not on, the minimum requirement is 15%, per HUD guidelines. This is important, you know. We see it all the time. A person thinks that a budget’s going to be X, and they finally get in, they start opening up walls, the utilities get turned on, whatever the case may be, and next thing you know, there’s a burst pipe, there’s mold behind the wall. There’s so many different things that can open up when you start opening up walls, opening up floors, really uncovering what’s inside of a property. The HUD consultant does the best that they can during the initial inspection, but ultimately, nobody can see behind walls. Nobody really knows what lies behind those walls, right? So that’s what the HUD consultant is there for, but that’s what also the contingency reserve is there for. The contingency reserve is great, too, because if everybody did a great job, and there’s no need to use the whole contingency, that money can be allocated to other projects. If we get done 80% of a project, all the mechanicals are in, the walls are all buttoned up, everything’s looking nice and neat and we’re just doing some finishing work, and we’re at 80% of the project and you’re sitting there with a nice big contingency reserve of $10,000 or $15,000 or $20,000, you could say to the HUD consultant, we didn’t include that one bathroom at the beginning of this project, and I’d really like to get that done, so since we haven’t used the contingency reserve yet, can we allocate those funds to redoing that bathroom? And again, that’s not an issue, so we definitely can do that as long as we’re further enough into the project to make that happen. The other thing to keep in mind when it comes to the contingency reserve if you’re doing the limited version of the 203K, that contingency reserve can only be used for health and safety-related items if there are overruns in that area. Something to keep in mind and a limitation of using the limited is that contingency reserve can’t be used for things such as upgrades, or to maybe do an additional bathroom. It’s really only there for the specific cost overruns that are health and safety related. Now, if the contingency reserve with either program is not exhausted and not used, the way you get your money back with the contingency reserve is how you put it in. 95%, 99% of the time, you as the borrower are going to finance your contingency reserve into your renovation budget. Once you’ve determined that the contingency reserve is not going to be used, or that there is leftover money, that money is going to go back against your principal into a principal reduction. However, in certain instances, and I’ve done this only a few times in my career, where we will actually do the contingency and the customer will actually put the contingency in as cash, and because as I said earlier how you put it in is how you can get it out, that is the only time you can get the money back from the contingency in the form of cash. Speak with your loan officer and speak with your HUD consultant about this, and they can help you to determine the best course of action. Listen, thank you so much guys. I really appreciate you being here today on this podcast.