How Does a Home Renovation Loan Work?
Posted on April 25, 2021 in Loans
If you’re wondering how home renovation loans work, our full guide will help you understand the different types of loans available, pros and cons, where to get a home renovation loan, and more. When looking to improve your home or make renovations, there are plenty of available options. However, your best bet may be to seek out a home renovation loan. This is everything you need to know about what exactly a home renovation loan is and how they work.
Making upgrades or the right repairs to your home can be a very wise investment opportunity that will not only add a considerable amount to its resale value, but can improve the comfort, function, style, and look of the home. However, these big property projects can get highly expensive and it may be fairly difficult affording them without a substantial home renovation loan. Whatever project it is that you are looking to undertake, it most likely will not be cheap.
For example, the average kitchen remodel in the United States will cost more than $23,000, the average bathroom remodel is $21,000, and even a relatively simple 16 x 20 foot wooden deck will be an average of $14,000.
How Do Home Renovation Loans Work?
A home renovation loan will be based on one key factor: the after renovation value. Renovation loans will use a home’s estimated after renovation value, as opposed to its current home value, in order to calculate how much money that a homeowner can borrow. This will give homeowners the necessary credit upfront for the increase in home value from the proposed renovation. There is often confusion surrounding this term as a result of some lenders offering so-called “home improvement loans”.
In actuality, these are not home renovation loans but are actually just rebranded unsecured personal loans that won’t be suitable for most projects because of their high interest rates, shorter terms, and limited loan size. When you’re wondering, “how does a renovation loan work?” It’s important to understand that a renovation loan is the only type of loan that will give a homeowner credit for a home’s future value. Using the after renovation value will help you to get the lowest rate possible, as lenders will typically set rates based on the loan to value ratio. There are plenty of different types of available renovation loans that will use the after renovation value of a home.
Whatever your project may be, the loan that you choose will have a huge impact because it will determine your interest rates, monthly payments, the total amount that you can borrow, and whether or not you’ll be required to refinance your first mortgage.
What Are The Different Types Of Home Renovation Loans?
The answer to how does a renovation loan work will vary based on the type you pursue. In other words, the way that a home renovation loan works will depend on the type of financing that you decide to apply for. The most popular home renovation loan options include:
Single Close Construction To Permanent Renovation Loan (CTP)
This is a construction loan, which is a type of renovation loan that will convert to a new permanent first mortgage and replace your existing mortgage in the process. Essentially, this option will work like a cash out refinance but will be based on the after renovation value of the home.
Construction loans will require that the money is paid to the contractor, not the homeowner, through a milestone based disbursement schedule that will require onsite inspections by the bank or lender.
Pros of these home renovation loans
- A low monthly payment. Just like dealing with a traditional mortgage, the monthly payment will be as low as it can be because of the option to spread the payments over a period of 30 years.
- Low interest rates. Rates will typically be in line with the market rate for first mortgages although some lenders may charge a premium.
- It’s possible to borrow over a million dollars.
- Has the option to convert into a traditional 30 year fixed or speciality offering such as an Adjustable Rate Mortgage.
- Single close will mean that you will only sign one set of documents and pay only one set of closing costs.
- It may be difficult to find a contractor to take on the project. Most contractors will refuse to get involved with a project using a construction loan, mostly due to the hassle of dealing with inspections and strict disbursement schedules.
- Because you will be refinancing, it’s possible that you will refinance at a higher rate. In addition, you will have to pay typical closing costs for a refinance along with the extra costs that will be associated with the construction loan, making it one of the more expensive loans on the market in terms of the cost of fees. You will also be starting the clock over on your mortgage when refinancing, which will slow down the rate at which you build equity in your home.
Fannie Mae HomeStyle Renovation Loan
A Fannie Mae homestyle loan is a specific type of construction loan, similar to the previously listed home renovation loan, that is insured by Fannie Mae, the government sponsored agency.
- The ability to borrow up to 95% of the future value of your home, although this will require you to pay Private Mortgage Insurance if you were to go above 80%. For the sake of comparison, a private bank will often limit a renovation loan to 80%, and even in the rare event that you find one that reaches 85% or 90%, a 95% loan is unprecedented.
- Single close will mean that you only sign one set of documents and pay just one set of closing costs.
- The standards for a borrower will not be as strict as those found with a private bank offering, meaning that elements like your credit score will not need to be as strong in order to qualify.
- This loan comes with the option to spread payments over a period of 30 years.
- Fannie Mae HomeStyle mortgage rates will typically be higher than the average interest rate that you will get by doing a construction loan through a private bank.
- Many contractors will refuse to undertake projects using home renovation loans like this one due to the inspections and disbursement schedule requirements.
- Due to the fact that you are refinancing, you will have to pay typical closing costs plus the extra costs associated with these types of loan, which can make it one of the more expensive loans on the market, In addition, you may have to refinance at a higher rate, You will also be restarting the clock on your mortgage which will slow down the rate that you build home equity.
FHA 203k Home Renovation Loans
An FHA 203K loan works in the same way as the Fannie Mae HomeStyle loan, but instead of being insured by Fannie Mae, this loan will be insured by the Federal Housing Administration (FHA), also a government sponsored agency.
- The ability to borrow up to 96.5% of the future value of your home, although this will require Private Mortgage Insurance if you go above 80%.
- Single close means you will only sign one set of documents and pay one set of closing costs.
- The standards for a borrower are very lenient. For homeowners without great credit scores, this is probably the best option available.
- Ability to spread out renovation loan payments over 30 years.
- FHA 203k mortgage rates will often be higher than all of the other renovation loan options.
- These loans will require mortgage insurance upfront and annually for the life of the loan.
- Contractors often refuse to take on projects with this loan type due to the inspection and disbursement schedule requirements.
- Refinancing will result in paying typical closing costs in addition to the extra costs associated with these loans. It could also result in refinancing at a higher rate, along with resetting the clock on your mortgage slowing down the rate that you earn home equity.
Home Renovation Loans Compared To Other Options
While it may be tough to find a home renovation loan, you should avoid borrowing using a financial product not specifically suited for home renovations. Here is how home renovation loans compare to other financial options:
Home Equity Loan
A home equity loan or home equity line of credit will allow you to borrow against the equity that you have built up in your home, but this will most likely not be sufficient enough funding to pay for the project. You will likely have to either reduce the scope of the project or find additional suboptimal lending solutions. For homeowners of over 10 years, this is less likely an issue, but for recent homebuyers a true renovation loan is the better option.
Personal Loans Or Credit Cards
This is arguably the worst option of them all, largely because these are considered unsecured loans that will require a much higher interest rate along with shorter terms. They will also have much lower limits, typically only $35,000 to $50,000 maximum, depending on the lender and other various factors.
Cash Out Refinance
Using a cash out refinance to pay for renovations will require your first mortgage to be refinanced. This will mean you will lose any lower interest rate that you have locked in, as well as having to pay significant closing costs that will come with first mortgages.
The Conclusion on How Home Renovation Loans Work
A home renovation loan uses the home’s estimated after renovation value in order to calculate how much money a homeowner is able to borrow. This is often the best possible option when considering large projects involving the home. If you’re still concerned about how a renovation loan works, be sure to seek professional advice.
While they may be difficult to obtain, a home renovation loan will offer lower interest rates and more borrowing power than other types of home improvement loans. Being able to borrow from the future value of a home, as opposed to the current one, will be very beneficial and can increase borrowing power by over 11x, making even the most expensive home projects affordable.
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