Mortgages and loans to pay for home renovations

Many homebuyers and homeowners don’t have enough cash to replace a roof, remodel a kitchen or build an addition to a home without borrowing the funds. A home renovation loan can help.

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• What is a home renovation loan?
• When to get a home renovation loan
• Home renovation loan options
• Home renovation loan projects
• How to choose a home renovation loan
• Costs and fees for home renovation loans
• Home renovation loan pitfalls

What is a home renovation loan?

A home renovation loan is a loan that includes funds for renovating, remodeling and repairing a home. It’s usually a mortgage with extra money for home improvements. It can be in the form of:

Some home renovation loans can be used to buy a fixer-upper and make upgrades at the same time, giving you one loan to repay.

Most home renovation loans require the borrower to have a certain amount of equity in the home. Personal loans are an exception because they’re unsecured loans.

When should you consider a home renovation loan?

Simply put, if you don’t have the cash to finance renovations or repairs, a home renovation loan is worth considering. It’s also worth pursuing if you have your eye on a home that has a lower asking price but needs serious work.

This loan can be used to great advantage by homeowners who want more control over building equity in their home by making improvements – but it’s a loan for substantial upgrades, not handyman work. If a project will improve the value of the place, a home renovation loan can be a valuable tool.

“I would only recommend taking out a renovation loan if the costs of the renovation are still well below the current value of the home,” says Gregg Harris, president of LenderCity Home Loans in Chesterfield, Missouri. “It is also important that they will positively impact the value of the home over the long run. So, things like bathrooms, kitchens and additions make the most sense.”

Home renovation loan options

There are several types of home renovation loans, so it’s important to understand the differences among the options before you start making plans.

Fannie Mae HomeStyle Renovation Loan

The Fannie Mae HomeStyle Renovation loan allows borrowers to either buy a place that needs repairs or refinance their existing home loan and get money for improvements.

One advantage of a HomeStyle loan is that it’s just one loan with one monthly payment; you don’t have to take out a loan for the mortgage and another loan for home repairs. Getting one loan cuts down on time and closing costs.

The loan money goes into a separate escrow account that’s used to pay contractors. Borrowers do not have access to those funds as they would with a home equity loan or cash-out refinance. In addition:

• Renovation costs are limited to 75 percent of the “after-repaired value” of the home.
• There are stricter credit score and debt-to-income ratio standards to qualify.
• It usually takes longer to close than a conventional mortgage loan.

FHA 203(k) loan

Credit score and down payment requirements are less stringent with a Federal Housing Administration 203(k) loan, also known as a 203(k) rehabilitation or rehab loan. There are two types of FHA 203(k) loans:

• Limited 203(k) loans are capped at $35,000.
• Standard 203(k) loans are for major rehabilitation or construction.

A standard FHA 203(k) loan requires a qualified 203(k) consultant to oversee every step of the work, from the plans to the finished product.

This home renovation loan is available for homes that are at least a year old, and the renovation project must cost at least $5,000. The FHA also sets mortgage amount limits by location.

Other features of an FHA 203(k) loan include:

• Affordable interest rates for those with imperfect credit, but lender fees may be higher
• Rehab funds are placed in escrow and released as the work progresses
• Funds cannot be used for a property that will be sold within 90 days

Home equity loan or HELOC

A home equity loan is a fixed-rate, lump-sum loan with monthly payments that remain the same for the loan term.

A home equity line of credit, or HELOC, has a credit limit and revolving balance. This loan works for homeowners who have several large payments due over time on a big home improvement project.

With either option, you’re pledging your home as collateral, meaning that if you don’t make your payments, you could end up losing your home.

There are other key considerations with home equity loans and HELOCs, as well:

• Interest rates on home equity loans and HELOCs are lower than they are on unsecured personal loans.
• With HELOCs, you pay interest only on the amount you withdraw.
• Equity loans may have upfront fees, such as application or loan-processing fees.

Cash-out refinance

A cash-out refinance allows homeowners to refinance their mortgage for a higher amount than the previous mortgage, based on how much equity they have, and take out the difference in cash.

Like home equity loans and HELOCs, cash-out refis require homeowners to use their home as collateral. A refinance works well if you can get a lower rate than what you’re paying on your current mortgage. A lower interest rate and an increase in home value as a result of renovations are great long-term benefits.

You’ll need at least 20 percent equity in your home to qualify for cash-out refinancing. The total loan amount is generally limited to the available equity in your home. In addition:

• There are no restrictions on use of the money.
• The loan is based on current home value, not post-improvement value.

Personal loan

An option for those who can’t or don’t want to tap home equity is a personal loan from a bank, credit union or online lender. Unlike a refi or home equity loan, a personal loan is unsecured, so you don’t have to use your home or any other asset as collateral. Loan eligibility is based on your credit score, income and financial history.

Naturally, consumers with “very good” FICO credit scores of 740 and up get the best interest rates on personal loans, which can be below 6 percent APR. Some lenders extend personal loans to consumers with credit scores as low as 580, though the rates on those tend to be much higher. You can quickly find lenders and interest rate ranges through Bankrate.

If you’re eligible, you could be ready to move forward with your new kitchen, bathroom or other home project.

Overall, the benefits of a personal loan include:

• Flexibility; loan can be used for most any purpose
• No home appraisal required
• Funding can be available quickly

Home renovation loan projects

Some home renovation loans can be used for most any improvement project you have in mind, while others have restrictions.

For example, the FHA 203(k) loan has a long list of eligible improvements, such as replacing a roof, flooring and plumbing, removing safety and health hazards and upgrading to accommodate a disabled person. However, the loan can’t be used for a luxury improvement, such as building a backyard swimming pool or hot tub, and the loan is only for primary homes, not second homes or vacation residences.

On the other hand, the Fannie Mae HomeStyle loan can be used to improve a vacation home or investment property, and any renovation or repair is eligible for funding, as long as it’s permanently affixed to the property and adds value to it.

If you borrow against your home equity to renovate your home, you can do pretty much any project you want, but you should consider whether the project will add to your home value. For example, new garage doors and a remodeled kitchen are considered high-impact upgrades that can help you recoup more of your investment when you sell.

A cash-out refinance can have the double benefit of letting you refinance a higher-rate mortgage to one with a lower rate, while pulling out cash to spruce up your property.

Personal loans, which do not require the borrower to use their home or other asset to secure the loan, also give the borrower lots of leeway regarding the type of improvements that can be made.

How to choose a home renovation loan

“The best way to choose a renovation loan is based on the best rate and lowest fees, but also a term that fits the monthly budget,” Harris says.

For example, if your credit isn’t great and you have little money to put down, an FHA 203(k) loan might be best, since you can get a mortgage with only 3.5 percent down.

Consider the scope of your project, how much you want to borrow and what your overall costs will be, as well.

“If a borrower has the ability to pull the money out of their home to pay for renovations via a cash-out refinance or a home equity loan or line of credit, the costs of obtaining money for the rehab or renovation would be less,” explains Michael Becker, loan originator and sales manager at the Baltimore retail branch of Sierra Pacific Mortgage.

“The problem with doing that is when you don’t have the equity in your home to pull out that cash,” Becker says. “If doing the rehab will add value to your home and you don’t have much equity in your home as-is, then a 203(k) loan or Fannie Mae HomeStyle Renovation loan may be your only option.”

It can be hard to determine the best home renovation loan for your needs, so work with a lender who has extensive knowledge of the different loans.

Costs and fees for home renovation loans

The costs and fees of a home renovation loan depend on the type of loan you get. With a cash-out refinance, you can expect to pay about 3 percent to 5 percent of the new loan amount in closing costs, which include charges such as the lender’s origination fee and the cost of a credit report check and an appraisal.

“Closing costs are higher on renovation loans, perhaps as much as 1 percent of the loan amount higher,” Becker notes. “Rates are also higher.”

A personal loan may have no fees but a much higher interest rate. Closing costs for home equity loans and lines of credit (HELOCs) are typically lower, but might include an application and appraisal fee.

The major cost, of course, is the interest paid on the home renovation loan, which can stretch over 20 or more years with some loans. A $50,000 renovation loan at 6 percent interest, payable over 20 years, will cost nearly $36,000 in interest by the time the last check is written.

Home renovation loan pitfalls to watch out for

Like any financial product, home renovation loans can have drawbacks if you’re not careful.

For example, some renovation projects are not worth what they cost – they aren’t going to add as much value to your home as you put into them. Adding an in-law suite or extra bedroom might fall into that category.

“The biggest risk is over improving a home,” Harris says, cautioning against spending so much that it exceeds the best possible value of the home over the long term.

When considering a home renovation loan, find out whether the renovations would increase the home’s value, and if so, by how much. Pay attention to the total amount you would have put into the home after the work is done, 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 spending more to purchase and remodel the home than what comparable homes in your neighborhood are worth, as this will affect your eventual sale price.

Cost overruns are another pitfall to avoid. When considering renovations, keep in mind that the total cost will probably involve more than just labor and materials. The total often includes fees for architectural and engineering services, inspections and permits, and potentially having to put up a contingency reserve of 10 percent.

If you’re considering a government-insured renovation loan, some of the restrictions and requirements might be considered a downside, as well. The Fannie Mae HomeStyle loan, for example, requires the lender to monitor the project and collect all the paperwork that supports it, including contracts, plans, appraisals and more. The loan can take longer to close because of this process.

Next steps

It’s a good time to apply for a home renovation loan because interest rates are very low. Before you apply, get your credit score and report so that you know what kind of borrower lenders will see you as. Also, it’s important to have a realistic idea of project costs and get the right type of loan, with the best rate you can qualify for and a payment that fits your budget.

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