How to Finance a Home Renovation

Buying a fixer-upper has become a trend in recent years, one that keeps growing with time. The idea is to purchase a home that needs a lot of work for a low price and then transform it into a dream custom home. As with any home renovations, though, you need money to make the transformation happen. That leaves one major question: where does one get financing for a fixer-upper or a big home improvement project?

Well, it turns out there are several answers to that one question. Buyers have multiple options to choose from when it comes to a home renovation loan, from personal loans to mortgage loans that include home renovation costs in them.

Home renovation loans

Whether you’re in the market for a fixer-upper or just want to upgrade your current home, that wide array of finance options comes in handy to provide financial assistance for sprucing up any of the dated finishes in your home.

“Financing a home renovation not only improves functionality and comfort for your family now, but strategic updates can also increase the value of your home and the future return on your investment if you decide to sell,” said Michelle McLellan, senior vice president and product management executive of home loans at Bank of America.

Loans for home renovations can be obtained at any point, such as the beginning of the purchasing process or even years down the line — as long as the borrower is eligible. It’s important to keep in mind that different renovation loans have different qualification standards that you’ll need to meet before you can get funding for your project. Some of these loans will also require that you show proof that the funds are being used to pay for labor and materials, while others allow funds to be used to the owner’s discretion.

Types of home renovation loans

Home equity loan

A home equity loan is an option for people who have established equity in their home. What that means in layman’s terms is that your home is worth more than you owe on it. For example, if your home is valued at $200,000 and you $100,000 left to pay on your mortgage, you have built up $100,000 in home equity.

Once you have established home equity, you can apply for a loan that borrows against the equity in your home, kind of like a second mortgage. Lenders will typically allow up to 80% of your available equity to be borrowed, based on your eligibility, of course.
If you have $100,000 of home equity available, the lender may allow you to borrow up to $80,000 to use. With a home equity loan, you’ll receive the requested amount in one large lump sum to begin using immediately.

With a home equity loan, you can also use the funds for other financial needs you may have at your discretion. The most common use of home equity funds is for home renovations because of the large amounts that can be requested, and this type of loan typically will have a lower interest rate than a standard personal loan. However, since funds aren’t required to be used for a home renovation, you can also use home equity funds for debt consolidation, tuition or other large purchases. These loans usually come with 5- to 30-year terms, so you’ll likely have some flexibility in how long you can take to pay it back.

Pros

  • Fixed interest rate: Most lenders will offer a home equity loan that has a fixed interest rate. This can keep you from having to worry about the rise and fall of interest rates that causes unpredictable payments.
  • Funds can be used for different things: Let’s say you borrowed more than you needed for your home renovation. You can use those extra funds for anything you need, like paying off high-interest credit cards or that dream vacation you’ve always wanted.
  • Lower interest rates than personal loans or credit cards: The national average for credit card interest is over 17%, so if you use credit cards to finance costly home renovations, it can lead to owing thousands of dollars in interest. With a home equity loan, your home is used as collateral in case you can’t or won’t repay it, which in turn allows lenders to offer lower interest rates.

Cons

  • Fees and closing costs: You’ll have to pay closing costs on a home equity loan because it is, in fact, considered a second mortgage. The lender usually charges between 2% and 5% of the loan amount for closing costs. Some lenders have special offers to waive those costs, but those generally come with eligibility standards, meaning not everyone will qualify for it. The lender may also charge a fee if you pay off your loan before the term is up.
  • Your home is collateral: Putting your home up as collateral could give you pause because it can put a home at risk of foreclosure if you can’t make the monthly payment or default on the loan.
  • Additional debt: It is important to point out that taking on a new loan will put you more in debt. If you have a dream of being debt-free within the next decade, this reality may deter you from borrowing more money from a home equity loan or otherwise.

Home equity line of credit (HELOC)

Much like a home equity loan, a home equity line of credit, or HELOC, is a line of credit available to you based off of your home equity. As with home equity loans, lenders will usually allow up to 80% of your equity to be borrowed against. The big difference, though, is that a HELOC is a revolving line of credit that you can borrow against several times during the life of the loan. It’s similar to a credit card; you can use a portion of the funds for home renovations (or other projects or bills) and when you pay it back, those funds become available for use again. You can also borrow smaller amounts rather than one lump sum, which lets you take out only what you need or want to use.

If your home is valued at $200,000 and you have $100,000 left to pay on your mortgage, the max amount your lender will allow for your credit line is probably about $80,000. If you want to use $20,000 to purchase your new kitchen cabinets, it will leave you with $60,000 available in your HELOC to spend on other purchases. If you choose not to use the extra funds during your draw period — the time period in which you can borrow against your equity — you’ll pay back the $20,000 at the end of the term. Or, you can borrow for another need from the remaining $60,000 again to use for any other large financial need.

You can also opt to pay back any money borrowed earlier than is required — in this case, the $20,000 — which will give you access to $80,000 and restore your full credit line during the draw period.

This gives you the option to choose to use your funds. However, these funds won’t be available to you forever. A typical HELOC term comes with a 10-year draw period — the time in which you can use the line of credit — and a 20-year repayment period —which is when you have to pay the remaining balance off and can no longer borrow from the HELOC.

Pros

  • Use funds only when needed: Having a revolving line of credit will come in handy if you don’t need all of the funds right away and the flexibility of being able to use the funds when needed can create peace of mind.
  • Low interest rates: A HELOC has a lower interest rate than other unsecured loans due to your home being used as collateral. Some HELOCs will come with an even lower introductory rate, usually for the first 12 months, depending on the lender.
  • No payments until you draw from it: If you don’t borrow from your HELOC, you don’t owe on it, so you won’t need to worry about paying it back until after you’ve used it. You’ll have access to the funds, but won’t have to think about monthly payments until you borrow against the line of credit. However, it is important to check your lender’s terms and conditions to see if you’re at risk of being charged an inactivity fee for not using it.

Cons

  • Variable rate: Most HELOCs come with a variable rate, so the interest rate advertised when you apply may not be the interest rate over the life of your loan. This can lead to unpredictable payments due to interest rates rising and falling. (Note: some lenders may offer a fixed-rate option that allows you to lock in an interest rate when you draw funds.)
  • Your home is collateral: When you borrow against your home’s equity, you’re putting your property at risk in case of nonpayment. If you choose not to make monthly payments or you default on the loan, your home could be foreclosed on.
  • Annual fees: There may be less fees associated with opening up a HELOC, but they usually come with an annual fee. A fee is often added to the balance of the loan and if you overlook this fee, it can cause more late fees to accrue or even cause your credit to take a hit.

FHA 203(k) loan

You’ve found the perfect neighborhood, but the cost of a move-in ready home is way out of your price range, so you opt to search for a fixer-upper instead. Well, in this situation an FHA 203(k) loan can come in handy. This type of loan is government-issued and geared toward borrowers who want to begin renovations right after closing on a home. It combines the cost of your mortgage with renovation funds, The funds for the home purchase and renovation are separated out, and the renovation funds are put into an escrow account. Contractors are paid directly from the escrow account as the renovation proceeds, which prevents financial or contractual mishaps and makes it ideal for people who are buying fixer-uppers.

To sweeten the deal, you can put down as little as 3.5% to secure your home and renovation loan. It’s important to note, though, that FHA 203(k) loans are only available to owners, occupants and nonprofit organizations. Investors are not eligible for this type of loan. It is also crucial for you to know what renovations you want to complete before the closing so you can request the correct amount and complete the renovations in the required 6-month timeline.

Pros

  • Renovations can start immediately: You can begin working on your dream home as soon as your loan closes rather than waiting for outside funding for renovations.
  • Flexible eligibility standards: The Federal Housing Authority protects lenders in case a borrower defaults on this type of loan, so some lenders will consider lower credit scores or nontraditional credit history for approval, which makes it easier to qualify, plus the application and funding process can be faster.
  • Low down payment: Like other FHA loans, an FHA 203(k) only requires a minimal minimum down payment, which can be as low as 3.5% down. This can be a budget friendly option for borrowers who do not have 20% saved for a down payment.

Cons

  • Extra fees: FHA 203(k) loans can come with extra fees tacked on, such as an ongoing monthly payment fee, an origination fee and a required mortgage insurance premium. Ask for a run-down of all the fees before you sign on the dotted line so you can be sure it fits into your budget.
  • Your home will be a construction zone: Unless you have temporary housing or funds to pay rent elsewhere, your home will be a construction zone for the six months you have to complete renovations. All renovations probably need to happen at the same time to meet that 6-month time limit, as it can be difficult to meet the time requirements while stretching them out to limit the construction zone.
  • No DIY work: FHA 203(k) loans require that you track all bids and work, as well as provide proof that you’re using a licensed contractor. If you want to use those renovation funds, you’ll have to pay for labor and can’t DIY it.

FHA Title 1 loan

This loan specifically helps fund home improvements and is issued through the Federal Housing Authority, which guarantees the loan through a private lender. Unlike the FHA 203(k) loan, this type of financing can be applied for after 90 days of ownership. It can provide some flexibility if you aren’t sure what renovations you plan to make since renovations don’t have to start immediately after closing on your home. It will give you time to assess you home and determine what your needs truly are. Funds can be used for anything that will make the home for livable and efficient, which includes appliances, accessibility for disabilities and energy efficiency, among other things. You cannot use the funds for any type of add-on that would be considered a luxury, though, like a pool, sauna or hot tub.

It is also important to note that there is a required debt-to-income ratio of 45% or less, and any amount above that could lead to an automatic rejection of your application, which could take this option off of the table for some homeowners.

Another crucial point is that any loans above $7,500 will require a lien to be placed on the home, so homeowners need to be sure to keep up with all of the paperwork and payments to avoid foreclosure.

Pros

  • No required equity: An FHA Title 1 does not require that you have any home equity built up, and you can apply for this loan at any time after 90 days of occupancy in your home.
  • Flexible timeline: You won’t have to have to wait to build up equity or do complete home renovations right after funding, so you’ll have the flexibility to apply at any point when you are ready to begin your improvements.
  • FHA backing: Lenders are protected by the FHA on this type of loan so they can consider homeowners with nontraditional credit history. This can make it easier to qualify if your credit is less than perfect.

Cons

  • Loan amount restrictions: With this type of loan, the maximum amount that a borrower can borrow for a single family home is $25,000. For homeowners who want to do major renovations, this could be a dealbreaker.
  • Fund use verification: You’ll be required to show proof of how the funds are being used and what improvements are being done. You’ll need to be extremely organized and meticulous about tracking your funds to avoid any hiccups along the way.
  • Extra insurance premium: You should expect to pay an extra insurance premium on this loan, which is usually around 1% of the loan amount. It can either be added to your payments or included in the interest rate.

Cash-out refinance

A cash-out refinance loan is when you refinance your mortgage but borrow more than what is owed in order to get some extra cash. The extra cash is based on the equity that you have built up in your home.

If your home is valued at $200,000 and you have $100,000 left to pay on the mortgage, you have $100,000 in home equity available to use. Lenders may allow up to 80% of that to be borrowed, which means that if you want to do a cash-out refinance and refinance the remaining $100,000 while borrowing the max $80,000, your new loan amount will be $180,000. The $80,000 can be used however you please, from home improvements to debt consolidation.

This can be an ideal solution if you would like one monthly payment, are in the market to refinance and have a good idea of the home improvements you would like to make. Homeowners aren’t required to borrow the entire 80%, so you can customize your loan amount to best fit your needs.

Pros

  • Lower interest rate/monthly payment: A lender may offer a lower refinance rate than your current interest rate. This can create a more budget-friendly option with a lower monthly payment.
  • Funds can be used for anything: There aren’t any restrictions on how you use the extra funds, so you don’t have to show proof of what the funds are being used for. If you use the funds for renovations and have some left over, you can spend them on other things.
  • Fixed rates: Cash-out refinances generally come with a fixed interest rate so your payments will not rise and fall with the index.

Cons

  • Must have home equity: If you haven’t built up home equity, you cannot take advantage of this option.
  • Closing costs: There are often closing costs involved with a cash-out refinance, just like any other refinance. These will usually cost you between 2% to 5% of the loan amount.
  • Your home is at risk: Even though using your home as collateral is standard protocol with mortgages and refinances, it is still important to consider whether you want to take that risk. It may also be a deal breaker if you’re lucky enough to have paid off your mortgage. Taking out funds against your home will always put you at risk of foreclosure if you default on the loan.

The final word

The decision to renovate a home can be both exciting and stressful, and finding the right solution for financing can be tricky. It’s important to closely examine your financial situation and speak with a variety of professionals in order to pick the right option for your situation. With the right financing tools under your belt, you can make your custom dream homes a reality.

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