Home Addition Loans: What’s The Best Way To Finance?

Posted on March 7, 2021 in Loans

For every homeowner, there will be a time where they consider an addition. When dealing with the same space for years on end, it’s only natural to want to improve or change that space. It may be adding a new bedroom, a new bathroom, or even a new deck or porch. Whatever the project may be, it’s important to consider the finances. While a new addition will almost certainly add equity to a home, hiring a contractor and paying for labor and materials will absolutely cost a substantial amount. The first thing to consider is if the overall equity increase will be worth the price of the project. 

In most cases, this answer will be yes, but it’s important to know for sure before getting started. The second thing to consider, and much harder to answer, is how to finance the project in question. There are many different ways to accomplish this goal, and here are a few examples.

Home Equity Line Of Credit

Also known as HELOC, a home equity line of credit is a type of financing that uses a first or second mortgage to tap into the equity of the home. Equity is the current value of the home at market price minus how much is owed on the mortgage. A home equity line of credit allows the homeowner to borrow against a percentage of the home’s equity at a variable interest rate. The funds would be made available in the form of revolving credit, similar to a credit card, and can be accessed at any time over a draw period of 10 years. 

During this time, minimum payments will often be low and may possibly only include payments on the interest. This will change during the repayment period, where the principal and interest is lumped into a monthly payment, usually over 20 years’ time. This option is best suited for anyone needing flexibility in their finances as both the amount and when it’s used can be altered accordingly. 

Home Equity Loan

This option is very similar to the HELOC in the sense that they both revolve around the equity of the home, but there are also key differences. A home equity loan will be given as a predetermined lump sum of money. It will be a percentage of the home equity and have a fixed interest rate with no draw period. As soon as the loan is taken out, the monthly payments will begin. This option is better for those that have an exact amount of money in mind and for a more strict repayment plan. A home equity loan, along with the HELOC, will both use the home as collateral. This means that failure to repay can result in foreclosure. While a HELOC doesn’t begin repayment until many years down the line, a home equity loan repayment will begin almost immediately. It’s important to remember that this loan, along with the first mortgage, will have to be repaid or the home could be forfeited. However, it’s not all bad as the interest rates are typically very low as a result of the collateral and length of repayment. The average interest rate for a 15 year fixed rate home equity loan is currently 5.8% which is much lower than the average for other types of loans. 

Cash Out Refinance

For anyone that does not choose to take out a second mortgage but has decent home equity, cash out refinancing can be a great option. The way it works is the current mortgage on a home will be replaced with a new one that is higher than what’s owed on the house. 

Along with this new mortgage, there will be a new interest rate and term length as well. The amount of available cash will be the difference between what is owed on the home and the amount of the new mortgage. Refinancing is also a good idea for any homeowner looking to get a lower interest rate than the one for the original mortgage. If your credit score has improved since you originally bought your home, then this option may be the best idea on the list. 

By getting the money needed to finance the project and lowering your overall interest rate on the mortgage, refinancing could end saving quite a lot of money in the long term.

Personal Loan

In the event of low home equity, there are other options available to a homeowner. Taking out a personal loan can be a quick and easy way to finance a project. Where HELOC, home equity loans, and refinancing will require lots of paperwork and inspections, obtaining a personal loan is often a fairly simple process. The lender, typically a bank or credit union, will review the credit history and income of a borrower and make an assessment as to whether the loan is approved or not. 

The term length of the loan will be set, anywhere between six and 84 months, and the interest rate will be calculated. The rate will vary as it’s primarily based on credit score, but the current average for a personal loan is about 11.8%. While this is more than double the rate of the average home equity loan, the terms are also much smaller as well. It will only take a few years to repay a personal loan, whereas a home equity loan is usually ten years at least. Personal loans will be repaid in fixed monthly installments over the course of the loan term. This can make it easier to budget for as opposed to revolving credit which will have a varying monthly payment due.

Credit Card

If the project isn’t too expensive then using a credit card may be the most simple and fastest option. Using a credit card for large purchases and projects can be quite risky, so it’s important to know exactly how much money will be needed before swiping a card. Credit cards generally have very high-interest rates, so this option should only be used for projects that can be easily paid off. After a purchase is made, there will be about a month before the charge will accrue interest. If the balance is zero, then interest will not be a factor. However, the average interest rate for a credit card is 14.6%, so anything owed after that month can start compounding interest and rack up a hefty bill quickly. 

In addition to this issue is that the card holder’s credit score can be negatively impacted as well. The higher the amount of credit being used on an account, the higher the credit utilization ratio will be. This number accounts for 30% of a credit score and is one of the most important factors influencing it. Maxing out a credit card for a home addition can not only cost money in interest rates and fees but damage a credit score as well.

Apply for a Home Addition Loan Today

Anyone looking to improve or repair their home will have many options available in terms of financing their project. Whether it’s using equity in the form of a line of credit, loan, or refinancing, or if it’s by taking out a personal loan or using a credit card, there are plenty of good options available. 

Financing a home improvement project can be a long and stressful process, but it’s important not to take shortcuts and to find the best option for your situation specifically. Some of the options listed above will take decades to repay and sort out, so it’s important not to rush anything. Take the time to figure up as close to the cost for the project as possible and choose the best option for you based on your specific financial details. This will not only save you money in the long run, but it can prevent you from getting into hot water financially and hurting your credit score, or even potentially losing the home itself.  

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