Mortgages and Loans to Pay for Home Renovations: Know Your Options

Photo to accompany story about using mortgage loans to pay for home renovations. Getty Images
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Is it working from home, or living at work? 

With offices remaining virtual and classrooms going online, more and more Americans are using their homes as their productivity center. According to a Stanford University study, 42% of Americans are doing their job remotely  – some for the first time ever. 

Spending so much time at home is making many people reconsider how the places where they live look, and what they can do to improve the great indoors. A 2020 study by real estate site Trulia found 90% of Americans planned home renovations this year, with one in five willing to spend up to $10,000 or more. 

Refurbishing outdoor spaces is top of mind for many homeowners, too, according to real estate agents who say stay-at-home orders have left people feeling trapped indoors. 

But before shopping for quotes or loading up on power tools, homeowners need to have a plan in place to pay for those home improvements and manage any overages due to unforeseen circumstances. The good news is that there are many different ways homeowners can finance their upgrades, from using specific construction loans for home remodeling, to unlocking the power of the equity they already hold in their home. 

Your first question: Is the cost worth it?

What is a Home Renovation Loan

A home renovation loan is a loan used to improve, remodel, or repair a home. This type of loan can be secured by the home itself and may even be an all-in-one purchase and rehab loan. You may also take out a home renovation loan well after you’ve already moved in, in the form of a home equity loan or a cash-out refinance. 

There is also financing available that isn’t backed by the property you are upgrading. Unsecured loans or lines of credit that you can use to remodel your home, such as a personal loan or personal line of credit.

When Should You Consider a Home Renovation Loan? 

Home renovations tend not to be cheap, and even a small project can go over budget. 

Some improvements are necessary, while others fall into the category of things that are nice to have but not essential. For example, a new furnace or appliance, or an extra bedroom for in-laws, may be immediately needed — but other projects, while they might improve your quality of life, aren’t an absolute necessity.    

The other key consideration is whether you are in good enough financial shape to borrow money for a home renovation. Especially at a time of economic uncertainty due to the recession caused by the pandemic, ask yourself whether you have a reliable source of income that would enable you to take on new debt. You should also have any other debt — including your mortgage, car loan and student or personal loans, and credit card debt — under control, and at least some savings in an emergency fund

And, crucially, you should know your credit score, the factor that influences more than any other the interest you will pay on the loan for your new project. If a low score would get you an unreasonably high interest rate, focus on building it up before embarking on a potentially costly endeavor.           

Home Renovation Loan Options

For homeowners who have equity in their home, using the value of their homes to finance home renovations can be an effective way to make their living spaces much nicer. 

When it comes to home financing options for renovations, there are three primary options homeowners should consider: government-backed loans, conventional cash-out refinancing, or a home equity line of credit. 

Government-Backed Loans

Fannie Mae HomeStyle Renovation Mortgage

  • Homeowners work directly with their contractors to determine the scope of work and budget. Together, they submit their renovation plans with the loan application. 
  • Renovation funds go into a custodial account, from which the contractor can request and withdraw funds. A construction specialist manages the loan, releasing funds as the work is completed. 
  • Homeowners must have at least 10% of their appraised costs in cash, to cover any contingencies that may happen during the construction. 
  • HomeStyle Renovation Mortgages require a minimum credit score of 620, and can be a good option for those trying to control their budget. 

FHA 203(K) Rehab Mortgage

  • Homeowners can perform upgrades on a home at least one year old, and this covers many common renovations: structural upgrades, replacing floors, upgrading to energy conservation improvements and more. 
  • Cost of renovations must be at least $5,000, and payments are managed by a construction specialist who oversees the contractors and their work. 
  • Lenders may charge higher fees for documentation and review, including architectural review and higher appraisal fees. 
  • Because borrowers must meet FHA loan guidelines, this option is great for those who have at least 3.5% for a down payment, a credit score of at least 620, and limited equity in their home. 

Cash-Out Refinance

  • Homeowners must have at least 20% or more equity in their home. 
  • Funds are paid directly to the homeowner, and can be used for any purpose, ranging from do-it-yourself upgrades to those from a licensed and bonded contractor. 
  • Lenders may add additional closing costs and fees, including appraisal and origination fees, which may be forced to be paid at closing. 
  • For homeowners who have a clear plan for their renovations, a cash-out refinance can be a great way to add value while taking advantage of historically low interest rates

Pro Tip

Before starting any renovation project, do your research on other homes in the neighborhood. If building a deck, a fence, or another architectural upgrade helped increase their property value, it could be an indicator of how a renovation could build your wealth.

Home Equity Line Of Credit 

  • Homeowners must have at least 20% or more equity in their home. 
  • Home equity lines of credit work like a credit card: homeowners are free to spend against the equity of their home as they see fit. 
  • These lines of credit come with a variable interest rate — if the prime rate goes up, you could be paying more to the bank for your project. 
  • High-wealth homeowners who are capable of paying off their home equity line of credit quickly can take advantage of borrowing at low rates, without adding time or money to their first mortgage. 

Costs and Fees For Home Renovation Loans

Each type of home renovation financing has different advantages and disadvantages. There is always a cost to borrowing, but how you pay for it, and how much you pay, varies depending on the type of loan.

If you are getting a loan, either rehab loan, personal loan, home equity loan, or a refinance loan, you’ll typically have to pay upfront fees in the form of closing or origination costs, in addition to ongoing interest. To get the lowest interest rate you’ll need to take out a secured loan, which is a type of loan attached to something of value. In the case of home renovation loans, a secured loan would typically be backed by the home itself.

You can usually avoid having to pay upfront fees with a line of credit, either a personal line of credit (PLOC) or a home equity line of credit (HELOC). But lines of credit usually have much higher interest rates than a traditional home loan. And they can have less favorable repayment terms, which could even include a lump sum balloon payment after a certain amount of time.

How to Choose a Home Renovation Loan

Choosing the right home renovation loan is highly dependent on your personal situation. Consider the cost of the project and the types of financing that are available to you.

Borrowing against your home’s equity is usually cheaper than getting an unsecured loan. However, you’ll need to have enough equity in your home to pay for the renovation. Most refinance loans or home equity loans allow you to have a combined loan-to-value ratio of 80% to 90%. So if your property is worth $300,000 and your mortgage balance is $230,000, you should be able to borrow up to $40,000.

If you don’t have much equity in your home, then you may need to take out a personal loan or open a personal line of credit. But regardless of which option you choose, you always need to shop around for the best deal. Banks, credit unions and other lenders will offer not only different interest rates and fees, but also different types of loans or loan terms. Having more options for financing home repairs or remodeling, will help you find the best deal you for you.

Alternatives to Loans for Home Renovations

An alternative way to fund home renovations can be a personal loan, if you have good enough credit and can negotiate an attractive APR. A personal loan may be especially attractive to fund a relatively minor expense such as fixing a leak or getting new appliances.

Another option to fund home improvements that do not involve major renovation can be a credit card. While cards typically charge far more interest than personal loans — and you should strive not to carry a balance month to month, so as not to pay that high interest — they may come in handy for smaller jobs.      

Besides standard credit cards, which might give you reward points or airline miles for your expenses, you can choose a co-branded card from home improvement or furniture chains. The Lowe’s Advantage Card, for example, offers discounts on certain purchases made at Lowe’s stores and no interest for six months on purchases of at least $299; the Home Depot Credit Card offers similar terms. IKEA offers a standard Visa card that earns cash back on all purchases, up to 5% for those made at its stores or on its website.

The IKEA Project Card is an example of a card that may be attractive for those who are looking to fund a renovation project without applying for a loan, since it offers 0% APR for up to 24 months depending on the amount purchased. APR jumps to a hefty 21.99% after that, so be sure to pay the balance off before then or you’ll incur interest payments higher than on a personal loan.    

Bottom Line

While borrowing against your equity can be an easy way to create the home of your dreams, it can also come with costs and downsides. Before talking to a mortgage officer, look at your overall budget carefully to determine how much you can afford, and how much value it will add to your home overall. 

Refinancing your mortgage to fund renovations doesn’t just have to feel right – it also has to be right for your lifestyle, your finances, and building your wealth. By taking a step back and evaluating all your options, you can determine which route is best for your personal situation.