What is a home-renovation loan?
A home-renovation loan is a type of loan, often wrapped into a mortgage loan, that includes the costs of renovating a “fixer-upper.”
You might consider getting one if you’re interested in buying a home at a lower price point and taking on the costs of fixing it up. Buyers choose to do this for a number of reasons, including personal pleasure or as a way to gain equity faster than they normally would when buying a move-in ready house, since you’re more in control of establishing the value of your house.
Home-renovation loans may cover costs such as installing or updating heating and cooling systems, energy improvements, roofing, waterproofing, mold remediation, etc., in addition to desired renovations like a new kitchen or bathroom that could add value to the house.
In many cases, an appraisal for a home-renovation loan will include up to 110% of the home’s after-improved value. This is particularly helpful if the home is in need of deferred maintenance, such as a hot water heater with one to two years of life left in it.
Remodel loan pitfalls to watch out for
In deciding whether to seek a loan, one financial issue is whether–and if so, how much–the renovations would increase the home’s value. Some projects may increase the value beyond their cost. But with others, you may not get back the cost of remodeling when you sell; some projects simply aren’t worth doing from a cost standpoint, although you may want to do them anyway because it improves your lifestyle. Think: Adding that in-law suite or extra bedroom.
When weighing renovations from a return standpoint, it’s a good idea to pay attention to the total amount you’d have in the home after finishing the work, relative to an appraiser’s estimate of the total after-project value.
You also want to consider the values of comparable homes in the neighborhood that have sold recently. A major pitfall lies in investing more in a home, through the purchase price and remodeling, than the values of these comparable homes, as they’ll affect your eventual sale price.
Should you get a home improvement loan? Here are core things to consider:
Combine saved cash with your home renovation loan
Consider combining cash with any of the other financing options. This may considerably reduce the total amount of interest you pay.
How to finance home improvements with your credit cards
Use a credit card to pay for your home improvement. Keep in mind details such as the possible rewards you could get on one side, and paying monthly charges in full and on time to avoid paying interest and/or late charges. For those small projects, only use zero (0%) or low interest credit cards when cash is not available. You may find 0% interest offers on new credit cards attractive, for projects under $15,000 (like that bathroom remodel), mostly because you plan to pay off the amount balance in a short period of time (12 to 18 months). The credit application and approval process is quite simple and there is no equity risk on your dwelling on this unsecured type of financing. Be aware, you need to understand the terms and fees of these credit card offers, especially that you are capable of paying off the full balance before the offer expires to avoid higher interest rates.
Should I refinance my mortgage and cash it out as a home renovation loan?
Another option may be a first mortgage cash-out refinancing. Be aware that the closing costs will often be substantially higher than those related to Home Equity products. Make sure you estimate the cost of your home improvement and the time it takes to pay off the loan. Home Equity products may save money on projects over a shorter period than a cash-out first mortgage. Always consider financing the projects that improve the value of your home. Look for information on which improvements or upgrades will boost property value in your area and never finance a major improvement if it increases the value of your property out of the comparable market.
Difference between a Home Equity Loan and a Home Equity Line of Credit:
A home equity loan, gives you money all at once, while a home equity credit line provides a source of funds that you can draw on as needed. These may be more suitable for the higher end of a mid-range size project. You should consider cost of financing and collateral risks vs. urgency and timeliness before choosing which one suits you best.
Consider one of six ways to pay for your home remodeling project:
If you’ve got it, use it. For those with the available funds, this choice will be the most obvious. If you plan to save and pay for each upgrade, try tackling one small project at a time. Using a credit card is also a possibility for a smaller home reno, as long as you’re able to pay that amount back before it accrues high interest.
- Mortgage refinance.
Refinancing your mortgage could give you access to a lower mortgage interest rate that yields a lower monthly payment. That’s why we always recommend a yearly check-in with your loan officer to keep your mortgage — and your finances — in optimal shape. Lowering your monthly mortgage payment with a refinance could free up extra cash that you could use to pay for your home renovation, as described in option number one. Your loan officer may also recommend a cash-out refinance that will allow you to access some of your home’s equity at up to 80 percent of its value.
- Home renovation loan.
This option works if you’re a homebuyer who plans to renovate as soon as you get the keys to your new house. Renovation lending programs like the FHA 203(K) Limited or Full or FNMA Homestyle (Conventional) loans allow you to borrow extra money, within one home loan, to fund a home purchase and its improvements. A home renovation loan can also be used to finance repairs. Each renovation loan product has different contingencies, maximum repair amounts, and timelines that can be explained in detail by your loan officer. The FHA 203(K) Limited, for example, requires home repairs to begin within 15 days and to be finished within six months of closing.
- Home equity line of credit (HELOC).
A home equity line of credit is taken out as a revolving credit line, using your home’s value as collateral. Similar to a credit card, a HELOC offers a line of credit that you can use to fund larger repairs or consolidate other loan debts. The interest on a home equity line of credit is normally tax-deductible and lower than other loan types. And like other mortgage loans, a HELOC could leave your house at risk if payments are delayed or stopped altogether.
- Home equity loan.
A home equity loan differs from a home equity line of credit in that it’s a second home loan used to access your home’s equity, without needing to refinance. A home equity loan may be a better option than a refinance if you have a large amount of equity available to you. The main difference between a home equity loan and a cash-out refinance is that the former creates a second mortgage on your home, while the latter converts your existing mortgage into another mortgage with different and more competitive terms. You may choose not to refinance your first mortgage if it already has a low interest rate. In this scenario, taking out a second mortgage makes more sense.
- Construction loan.
This final option can work well if you’re a homeowner bringing out the big guns — rebuilding a portion of your house or doing a total flip. Construction loans are harder to come by and have more stringent requirements. In most cases, a construction loan is granted as a short-term loan, and money is released in stages until the renovation is finished.
Alternatives to a Home Renovation Loan
If you have very healthy credit and a less expensive project in mind, you can use a credit card with a promotional no-interest period as an alternative to a full renovation loan. Isolating your project costs on a separate credit card will make it easier to keep those expenses separate from your usual spending, while a no-interest offer will minimize the cost of borrowing the money. Just remember that it can be easy to overspend with a credit card, so make sure you’re confident you can use it responsibly and repay the balance quickly.
There’s also the cash-out refinancing option, which involves refinancing your current mortgage at a higher loan amount and using the extra cash for a renovation. This choice might make sense if you have at least 20% equity in the home, a good credit score and low interest rate options available in the market. Look carefully at current rates, lenders, and how much equity you have in your home before choosing to refinance.
The best choice for you will vary significantly depending on your situation. If you want to make home repairs on your new home right away, the lower rates and closing costs of a home renovation loan make the most sense. If you’ve already built up some equity in your home, you can take advantage of a strong market with a home equity loan to increase the value of your home. Credit lines or cash-out refinancing are worthwhile considerations when interest rates are low and your credit is healthy.