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Pros and Cons of a Construction Loan for a Remodel

Written by Marc Guberti

Marc Guberti is a Certified Personal Finance Counselor who has been a finance freelance writer
for five years. He has covered personal finance, investing, banking, credit cards, business
financing, and other topics.
Marc’s work has appeared in US News & World Report, USA Today, Investor Place, and other
publications. He graduated from Fordham University with a finance degree and resides in
Scarsdale, New York.
When he’s not writing, Marc enjoys spending time with the family and watching movies with
them (mostly from the 1930s and 40s). Marc is an avid runner who aims to run over 100
marathons in his lifetime.

Updated January 23, 2024​

3 min. read​

construction loan for remodel

The average home renovation costs between $15,000 and $20,000. Some renovations can stretch beyond $20,000, and not every homeowner has enough cash in hand to afford the renovation. Some homeowners can save enough money for the renovation, but not everyone has the luxury of time. Water damage will get worse, and an immediate home renovation is the best solution. Some homeowners prefer to get it over with instead of drawing out the process for several years.

Loans speed up the path to a house renovation. Financing covers the difference when you’re short on funds. You can make monthly payments towards the principal instead of delaying the project. Homeowners can review several financing options, such as construction loans. We’ll cover the pros and cons of these loans and show you how you can provide the necessary funds for your home renovation.

Construction Loans: Overview

Construction loans provide you with enough funds for your house renovation. This short-term financing source is specialty financing that covers custom home-building costs. Borrowers take out construction loans for extensive renovations or constructions. Construction loan lenders provide the principal in chunks based on milestones instead of giving it all to you at once. You’ll have to jump through several hurdles to receive approval for additional funding, such as an inspector’s approval and signature.

Can You Use a Construction Loan for a House Renovation?

You can use a construction loan for a house renovation, but it has to be large in scale. Their high fees and interest rates make them unattractive for homeowners, but it’s technically possible to use one of these loans.

Benefits of Using a Construction Loan for a House Renovation

Construction loans have many disadvantages for homeowners, but they have some benefits. You can borrow more money from the lender since financial institutions assess loan applications based on the post-construction value of the home. For example, if your home is worth $500,000, and the renovation will raise your home’s value to $600,000, you can borrow money as if your home already had the $600,000 valuation. 

Construction loans also provide short-term relief from debt. You only owe interest while constructing the property and can hold off on principal payments. While this offers a blanket of security for some homeowners, the post-renovation surprise can cause significant financial stress. 

Drawbacks of a Construction Loan for a House Renovation

We’ve covered a few benefits, but construction loans come with substantial risks. We’ve outlined some of their drawbacks below.

  • Stringent Requirements and Complicated Process: Lenders take on significant risks with construction loans. They work with borrowers with unfinished properties. Even though you’re only looking for a renovation, lenders will hold onto their stringent credit score and architectural planning requirements. You’ll also have to raise more money for a down payment.
  • You Pay More Due to Refinancing: You must refinance your current mortgage if you get a construction loan. Interest rates are already rising, but construction loans have higher rates than mortgage loans. You’ll end up owing more debt if you take out a construction loan. This disadvantage alone stops many homeowners from pursuing this option.
  • Higher Closing Costs: Construction loans let you tap into more funds since lenders consider your property’s value after the project gets completed instead of current home equity. However, this structure also leads to higher closing costs. Lenders use a percentage of the loan to determine closing costs. A higher principal translates into more expensive closing costs, limiting your ability to use initial funds for a home renovation.
  • You Won’t Get Your Money Right Away: A construction loan isn’t like most financing options. Lenders give you some of the money upfront instead of the entire principal. You will only receive more of the loan amount if the project reaches certain milestones. Any delays with the renovation will further restrict your access to capital.
  • Frequent Property Inspections: You’ll need several property inspections before accessing the next allotment of funds. Property inspections on construction sites make more sense. You wouldn’t want to build on a shaky foundation. Home renovations have fewer risks. Inspections can help, but several of them can get overwhelming. You’ll have to call inspectors, meet with them, and have several of them in your home. Not everyone is comfortable with this level of property inspection, but it’s a requirement for each stage of a construction loan.

Reasons Why Contractors Don’t Like Construction Loans

It’s not just homeowners who struggle with construction loans. Many contractors do not enjoy working with these loans. They would prefer financing from another loan or for the construction company to provide the cash. So why would the professionals not want these loans? We offer some reasons below.

  • Require a Lot of Work: You’ll have to jump through several hurdles to access each portion of the principal loan. Financial institutions take on a substantial risk when lending money to contractors. They will complicate the process if it keeps their money safe.
  • Slow Down the Project: Since contractors won’t receive the funds right away, they may get financially trapped earlier than expected. Several inspectors have to review the current structure before you can move to the next stage of funding. You’ll have to schedule meetings with inspectors selected by the bank and then approach your lender with the signatures. These delays can add weeks to each step of the construction and limit a contractor’s ability to take on new projects.
  • Lots of Paperwork: Both of these disadvantages involve paperwork. You’ll need the right documents for each draw. Conventional loans only require paperwork once. Once you get a traditional loan, you can use all of the funds. Paperwork for a construction loan will accumulate and can make your mind numb. Contractors already have a lot of responsibilities to juggle with their projects. Additional paperwork slows them down and leads to stress.

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