How to Use Sweat Equity in Real Estate?CASAPLORERTrusted & Transparent
- A sweat equity loan allows a buyer to purchase a house with no cash down payment if the buyer works on improving a home before the purchase.
- Getting sweat equity for a house is different from buying a house with a regular mortgage because it requires a lot of coordination between a buyer and a seller.
- Newly renovated houses may not work for sweat equity while old houses that require repairs may be a much better option for this loan.
What Is Sweat Equity?
Sweat equity is a loan provision that is offered by the Freddie Mac Home Possible mortgage program and FHA loans. This offer allows a buyer to get a mortgage for a house with loan-to-value (LTV) ratio up to 97% and no cash down payment if the buyer is willing to earn their down payment by improving the house before the purchase. With this offer, the buyer improves the property by themselves, which in turn increases the value of their home. The amount of skilled labor and the costs of materials required to make the improvements will then be used to estimate how much a buyer earned for their down payment. It is important to note that sweat equity net expenses are taxable just like an employment income.
Certain limitations apply to this type of program. First, the buyer has to know how to fix and make improvements to the property. It is possible to hire contractors to do the job, but in this case, the expenses may be equal or even outweigh the sweat equity a buyer gets from the job done. Additionally, the buyer has to have enough money to purchase the materials needed to make improvements. Lastly, the buyer has to be allowed by the seller to work on their house before actually buying it.
A buyer who is interested in this type of offer should talk to an agent who offers FHA loans or Freddie Mac Home Possible loans. This program is open to any buyer who meets general criteria for a loan. Freddie Mac Home Possible program has an eligibility tool that allows buyers to assess their eligibility for different properties.
How Does Sweat Equity Work?
Before going for a sweat equity offer, it is important to find the right house for the program. A house that is newly renovated may not be the best house for the program because further improvements might not bring as much value. On the other hand, houses that are old enough and require some work may be a great way to build equity through the sweat equity program.
Another important determinant of which house to pick is the seller's willingness to allow a potential buyer to improve their property. The program implies that the house is sold after the improvements are done. This means that the buyer works on a property when it is still under the ownership of the current owner. Some owners may not be comfortable with it, so there is a chance that they will not accept this arrangement. Before applying for the program, a buyer must ensure that the seller is comfortable with the property being renovated while they still own it.
If the buyer and the seller come to a mutual agreement, a buyer should contact their real estate agent to draft a contract that outlines what improvements will be performed and explain what will happen if the deal does not close. As soon as the sweat equity agreement is signed by both parties, the buyer can start working on the improvements. There is a time limit when all improvements must be completed. As a rule of thumb, all the improvements must be completed before the buyer takes ownership of the property. This means that the buyer has to be done when the mortgage loan closes.
During the process of home improvement, the buyer should also be aware that an appraiser will be closely monitoring the progress. The appraiser will be there to reevaluate the value of the property based on the developments completed and ensure that the materials and end product matches the provisions in the agreement.
Sweat Equity vs. Down Payment
The biggest advantage of sweat equity is that it can replace a down payment for a house. Normally, a borrower has to pay cash for a down payment on a mortgage. The most common ways to avoid spending cash for a full down payment are by either getting money as a gift, finding local down payment assistance, or using a piggyback loan. Sweat equity provision offers another way to bypass spending cash on down payment and allows a buyer to “earn” their down payment. The down payment is earned through house improvements that will increase the appraised value of a property after the improvements are completed. Using sweat equity, a buyer can earn a down payment from the value of the labor and cost of materials used for improvements.
For example, let's say a buyer wants to get a house for $70,000 that requires some improvements. Suppose, the cost of materials used is $5,000, an hourly wage of a skilled laborer is $30 per hour and it requires 200 hours to complete the job. After the job is completed, the buyer can ask for $11,000 for a down payment to be paid using sweat equity. The buyer should ensure that they document the cost of their labor and the costs of the materials required to get sweat equity.
Steps for Getting Sweat Equity
Getting sweat equity for a house is very different from buying a house with a regular mortgage because it requires a lot of coordination between a buyer and a seller. Additionally, an appraiser has to be present quite often to assess the quality of work and value of the property. The following steps should be taken to ensure that the buyer can qualify for a sweat equity loan.
Step 1. Get Pre-Approved for Sweat Equity Loan
Before jumping into the process, a buyer should ensure that they can get a sweat equity loan. They should find a lender who offers loans with a sweat equity provision and get pre-approved for a home purchase.
Step 2. Find an Appropriate House
Not every house is appropriate for this type of loan. For example, a newly renovated or newly built house may not need any improvements, so it will not be eligible for the program. On the other hand, a house that does not have a finished basement may be a good option to build sweat equity. Instead, a buyer should look for an old house or a house that is sold “as-is” to make sure that it needs some improvement. A buyer who feels confident in their ability to improve a house may even look into buying a foreclosed home because they tend to be cheaper but require a lot of work.
Step 3. Talk to the Seller
When a desired house is found, a buyer has to contact the seller of the house to get approval for improving their property. It is an essential step in getting sweat equity because the house is bought after the property has been improved. This means that the buyer will work on the property that is still in the possession of the seller.
Step 4. Negotiate the Price
A buyer should try to negotiate the price of the house before and after the repairs to get the best deal possible. Since a buyer will be purchasing the house after the repairs are completed, the buyer should expect a higher purchase price than the price currently listed. It is wise to discuss the future price before getting to work to estimate the benefit of working on the house.
Step 5. Find an Appraiser
A buyer will have to work closely with an appraiser during the improvement process. It's best to find one appraiser who can dedicate time for the project. An appraiser will estimate the value of each improvement and estimate the value of the house after the improvements are completed.
Step 6. Make an Agreement
After the value is calculated, a buyer should contact their real estate agent to draw an agreement indicating what improvements will be made and the final purchase price of the house. That agreement must be signed by the buyer and the seller before proceeding to making improvements.
Step 7. Work on Improvements
It is now time to earn sweat equity. At this step, the buyer can start buying materials for the improvements and start working on the improvements. It might be required for an appraiser to check the progress a few times during the process to ensure that all improvements agreed have been completed and the materials outlined actually have been used.
Step 8. Final Inspection
After all the improvements are done, the buyer should contact an appraiser one more time to document that everything has been done. The appraiser will look at all the improvements and estimate the value of the house one more time.
Step 9. Close on the Mortgage
When the buyer has all required documents from the appraiser, they can close the mortgage on the house and close the deal. At this point, the title ownership will be transferred to the buyer, and they will get sweat equity.