Your home is probably one of your most important assets, so investing in it with a remodel or addition is a great way to add value. But what’s the smartest way to pay for those renovations? Here a few of the best home improvement financing options.
Home equity loan or line of credit
Owning a home doesn’t just give you a roof over your head, it can also serve as a valuable, and growing, investment. Over time, as you pay down your mortgage, you build more and more equity. If you choose, you can borrow against that equity for a range of expenses, like paying off high-interest debt, covering the costs of an emergency, or using it to reinvest in your home and further increase its value.
Two popular ways to access your equity are through 1) home equity loans or 2) home equity lines of credit (HELOC). While similar, there are a few differences:
Home equity loan
A home equity loan typically comes as a lump sum of cash, often with a fixed interest rate and predictable monthly payments, similar to your first mortgage. These will normally come with closing costs that range from about 2%-5% of the value of the loan. The term or length of the loan can range from 5 to 30 years.
Interest rates will usually be much lower than other types of personal loan options, so experts recommend these over credit cards for example, in order to pay for home improvements.
Home equity line of credit
A home equity line of credit works more like a credit card where you can borrow what you need as you need it, up to a certain limit. Unlike home equity loans, HELOCs will have few, if any, closing costs and will likely come with variable interest rates.
Unlike the predictable monthly payments common with a home equity loan, the line of credit usually comes with 2 payment phases: 1) the draw period and 2) the repayment period. During the draw period, typically the first 10 years, you’ll make small, interest-only payments. During the repayment phase, you’ll be required to make principal plus interest payments until your balance is paid off, and you won’t be allowed to borrow any further against your line of credit.
How much can I borrow with a home equity loan or line of credit?
Your maximum loan amount will depend on the value of your home, what percentage of that value the lender will allow you to borrow against, and how much you still owe on your mortgage.
For example, let’s say your bank will let you borrow up to 80% of the value of your home. It’s currently worth $300,000 and you still owe $150,000 on your first mortgage. That means you may qualify to borrow an additional $90,000 in the form of a home equity loan or HELOC ($300,000 x 0.80 = $240,000 – $150,000 = $90,000).
- Access to lower interest rates than credit cards.
- If you use the loan for home improvements or renovation, the interest may be deductible.
- Higher interest rates than refinances.
- If you decide to sell your home before you’ve finished paying back the loan, the balance of your home equity loan will be due.
Good option if: you need access to additional funds and already have a low interest rate on your first mortgage (i.e., you don’t want to replace it outright by refinancing — see next section).
Cash out refinance
Another home improvement financing option is a cash-out refinance. Like a home equity loan, this also provides a lump sum payment and usually comes with fixed interest rates. But a cash out refinance isn’t a second mortgage. This is a new home loan that replaces your existing mortgage, and is valued at more than you owe on your house. That difference is the “cash out” portion, which goes to you.
In order to qualify, you must have equity built up in your house, and the cash-out amounts are limited to 80% to 90% of that equity. Here’s how it works…
Your home is currently valued at $400,000 and your mortgage balance is $200,000. That means you have $200,000 of equity in your home. You don’t need to refinance as much as 90% of that balance, so you opt for 50% instead. Your new refinanced loan is for $300,000 — the existing $200,000 balance plus 50%, or $100,000. You receive that $100,000 in a lump sum at closing to pay for home renovations.
- Access to lump sum payment.
- May give you a lower interest rate if your original mortgage had a much higher one.
- Interest may be deductible if the money is used to buy, build or substantially improve your home.
- It’s not a second mortgage
- A cash-out refi may be easier to qualify for than a home equity loan.
- You’ll typically pay up to 2% to 5% of the mortgage in closing costs.
- You’ll likely be required to pay mortgage insurance premiums if you borrow more than 80% of your home’s value.
Good option if: you need access to additional funds and can secure a lower interest rate than you’re currently paying.
Renovation or construction loan
A third loan type to help with your home improvement financing is a renovation or construction loan. These generally allow you to access more funds than you could otherwise because they let you borrow against the value of your home after the renovations are complete. But there are some strings attached. Let’s look at a few of the most common types of these loans:
Fannie May Homestyle renovation loans
These are conventional loans backed by the federal government, so they’ll come with a fair amount of oversight. First, you’ll need to adhere to some strict credit requirements like a credit score of at least 620 and a maximum debt-to-income ratio of 45%. You’ll also need a down payment — typically 3% for a single-unit home.
Some other conditions apply as well. You’ll need to work with a contractor beforehand on your renovation plans and submit them to the lender for approval. The lender will then review those plans and determine the post-remodel value of your home (and how much you can borrow).
Once the project gets underway, the lender will periodically inspect the project work to make sure it aligns with the initial plans and will result in the “as-completed” value they projected. If it doesn’t, that could affect funds it releases to you and your contractor. Once the work is completed, the lender must issue a final approval.
This type of home improvement financing does have a high plus side: Generally you can borrow more than 80% of the home’s post-remodel value, so if your house is currently worth $350,000, but after renovations, it’s expected to be valued at $450,000, you can borrow up to $360,000 (80% of $450k). That’s can be a huge benefit that allows you to access additional funds you may not otherwise have been able to.
- Can refinance and remodel your home with a single loan.
- Access to more funds than your home is currently worth.
- Can use to renovate primary or second/investment homes.
- More paperwork and regulation than other loans, like HELOC or cash out refinance.
- Project must finish within 12 months of closing.
- You need to work with contractor to draw up plans for the renovation for the lender to approve.
203(k) renovation loan
This type of home improvement financing lets you use a single loan for both a home purchase and the renovation costs it may need. This can be useful if you’re buying a fixer-upper for example. These are also government-backed, guaranteed by the Federal Housing Authority (FHA). That means there are fewer risks for the lenders when offering these loans, which can translate into lower rates for you.
This differs from the Homestyle loan in that you can only borrow up to 110% of your home’s future value post-renovations. With what’s called a “Standard” 203(k), you can use the loan for major renovations, but it requires a 203(k) consultant — usually a licensed contractor or architect — to oversee the work from start to finish. He or she will act as a liaison between you, your contractor, and the lender. The consultant is meant to keep the project on track and signs off on the release of funds from the lender to the contractor.
You as the borrower need to find and pay for the consultant, which can run up to $1,000. You can check the US Department of Housing and Urban Development for a list of approved 203(k) consultants.
In addition, with this type of loan, you’ll be required to pay upfront and annual mortgage insurance premiums for the life of the loan.
- Interest rates may be lower than other loan types and things like credit cards to pay for renovations.
- Can access up to 110% of post-remodel value of your home.
- Don’t need high credit scores to quality. 580 can qualify for a 3.5% down payment.
- Loan limits may be lower than conventional mortgages.
- Must find and pay for 203(k) consultant.
- Must pay mortgage insurance premiums.
Good option if: Renovations loans can be good if you need to borrow more than your home is currently worth and want to refinance and remodel your home with a single loan.
Local bank renovation loan
This type of loan also lets you borrow against the post-renovation value of your home, but it typically comes with fewer regulations. You can use them to remodel an existing home, a second or vacation home, and even an accessory dwelling unit (ADU). Options range from minor updates to major renovations.
Similar to the government-backed loans noted previously, you’ll still need to submit work plans to the lender, but the lender will have their own team that inspects work progress and approves the disbursement of funds to pay for ongoing construction. You’re not required to hire a separate consultant as in the case of a 203(k) loan.
The main benefit of this type of home improvement financing is that your local bank can generally approve your application and ongoing work more quickly, with fewer hoops to jump through, so your project can be completed in less time. You may already have a relationship with a loan officer at your bank as well, which could also help ease the loan process.
- Fewer regulations.
- Can borrow against value of home post-remodel.
- Not required to pay for outside consultant to approve construction work.
- Can see a quicker approvals throughout the process.
- Mortgage rates may be somewhat higher than government-backed loans.
- More preparation is involved vs. a home equity loan.
- Not all banks offer special renovation loans.
Good option if: you already have a local bank you have a relationship with, you need to borrow more than your home is currently worth, and want to avoid the regulations that come with government-backed loans.
Related posts: Learn more about renovation costs
For more ideas on how to help plan and budget for your next remodeling project, check out: