You dream of renovating your home but can’t afford the costs out of pocket. A construction loan is an option to fund the project even if you don’t have a ton of equity in your home, but is it most ideal? Not necessarily.
Read on to learn more about how construction loans work, why they’re not always the best option for a remodel and RenoFi, an alternative worth considering to fund your home renovation.
Home Renovation Loans
What Is a Construction Loan?
A construction loan caters to individuals who want to build a home from scratch. However, they’re also used for home renovation projects that are large in scope.
How Do Construction Loans Work?
Unlike traditional mortgages, construction loans are short-term loans accompanied by steep fees and interest rates. Furthermore, the funds aren’t disbursed in a lump sum when you’re approved. Instead, the contractor working on the project will receive installment payments throughout the project. This process is referred to as a progressive drawdown.
The contractor must make a request for a draw and meet specific requirements before the funding request is approved. This usually entails inspections, several signatures and in some cases, mechanic lien waivers, which means it could take up to a week or longer for the contractor to get paid.
When the project is complete, construction loans are generally converted into a permanent mortgage.
Can a Construction Loan Be Used for Remodeling?
Although it’s not their intended use, construction loans can be used to finance home renovations. Homeowners sometimes prefer these loans over other forms of financing because they’re based on the home’s after-renovation value, which increases your borrowing power.
Home Renovation Loans
Reasons Why Construction Loans May Not Be Best for a Remodel
Are you considering a construction loan to remodel your home? Be mindful of a few significant drawbacks.
For starters, lenders have a complex draw process that can be frustrating for both the homeowner and the contractor working on the renovations. The property will be subject to several inspections during the renovation. Construction loans also require loads of paperwork to keep the project moving smoothly. Plus, loan proceeds are released incrementally as project milestones are met, which could result in delays.
You’ll also have to refinance your current mortgage if you get a construction loan. This can be costly if your current rate is low – a slight increase of one percent means several thousand dollars more paid in interest over the life of the loan.
Case in point: if you have a 30-year fixed-rate mortgage of $350,000 and the interest rate is 3.25 percent, you’ll pay $198,359.96 in interest over the life of the loan. But if the interest rate increases to 4.25 percent, you’ll pay $71,484.30 more in interest, or $269,844.26.
There’s also a significant difference in the monthly payment for principal and interest. The monthly payment for the loan with a 3.25 percent interest rate is $1,523.22. However, you’ll pay $1,721.79 per month for the loan with the higher interest rate. That’s a difference of $198.57.
Plus, the closing costs are sometimes steep as they’re based on your outstanding mortgage balance and renovation budget. To illustrate, if your current mortgage is $450,000 and your renovation budget is $150,000, you will pay closing costs on a $600,000 loan. Closing costs are usually around 3 percent, so that’s a whopping $18,000 ($600,000 * .03), compared to $4,500 ($150,000 * .03) if you only paid closing costs on the amount borrowed for renovations.
RenoFi Loans: An Alternative Way to Finance Your Home Improvement
Contractors aren’t a fan of construction loans for renovations, and for many reasons. Fortunately, there’s a better alternative to finance home renovations that’s more efficient and affordable.
RenoFi Loans offer the same increased borrowing power as construction loans, minus the hassle that comes with draws, inspections and extensive contractor involvement.
Homeowners can choose from a RenoFi Home Equity Loan, RenoFi HELOC or RenoFi Cash-Out Refinance. You won’t have to refinance your home, go through a series of inspections throughout the renovation process or pay high closing costs.
Instead, RenoFi loans act as a second mortgage, which means you get to keep your current mortgage rate. Even better, loan proceeds can be for renovations on your current home or a home you’re buying.
You’ll need a 640 credit score to qualify, and you can borrow up to 90 percent of your home’s after-renovation value minus what you owe on your mortgage (limited to $500,000 – loan amounts of $250,000 are subject to stricter eligibility requirements).
To illustrate, assume your home is worth $395,000, and you owe $255,000 on your mortgage. You plan to have renovations completed that will increase your home value by $75,000. In that case, you could qualify for a RenoFi Loan of up to $168,000 ($395,000 + $75,000 * .90 – $255,000).
There are no restrictions on the types of home improvements you can make using the funds, and you’ll have up to 30 years to repay what you borrow depending on the loan product.
Ready to get started? Here’s how the process works:
- Step 1: Use the RenoFi Loan Calculator to gauge your borrowing power. You can also view estimated interest rates and monthly payments for home renovation loan products from credit union partners in the RenoFi network.
- Step 2: If you wish to move forward, input the requested information in the RenoFi self pre-qualify tool. Assuming there’s a match, you will automatically be assigned to a RenoFi Advisor who can answer any questions you may have.
- Step 3: Collect the documents you’ll need to apply for a loan. Start by gathering your contractor’s contact information, a detailed cost estimate for appraisal, renovation plans the contractor will use and the preliminary renovation contract. Lenders will also request financial documents, including your two most recent pay stubs, two years of W-2 forms, your most recent mortgage statement and proof of homeowners insurance. Also, prepare to provide statements from the prior two months for bank accounts, investment accounts and retirement accounts.
- Step 4: Work with your RenoFi Advisor to identify a lender and loan product in their credit union network that best suits your needs.
- Step 5: Apply directly with the lender to secure your RenoFi loan.
It’s that easy, and your dedicated RenoFi Advisor is available to assist every step of the way.
Maximize your borrowing power and get a monthly payment you can afford with a RenoFi loan. Take the first step towards completing renovations and creating your dream home today.