how home renovation loans work

How Do Home Renovation Loans Work? 

how home renovation loans workWhether you’ve chosen to purchase a fixer-upper home or your existing home simply needs updating and refreshing, there’s no doubt it’s a costly project. Since most people don’t have the money up front to pay for renovations, many choose to take out a loan to cover the cost. However, most existing types of loans aren’t primarily designed for home renovations. 

You can take out a tailored loan for car repayments (auto loan), college fees (student loan), or a house purchase (mortgage). Each of these takes the purpose into consideration, and the repayments are structured around it. It’s not widely known that a loan specifically for home renovations exists. 

The great news is that a home renovation loan can secure you super low rates. Let’s take a close look at what home renovation loans are and how they work.

What is a Home Renovation Loan?

A home renovation loan is different from an unsecured loan because it bases the credit amount on the home’s future value. After you’ve completed the renovations, the value of your home will rise, so the lender looks at that increased value amount and bases the credit on it.

The after-renovation value will also secure you the lowest rates as lenders base the rates on the loan-to-value ratio. Essentially, taking the after-renovation value into account means that you can borrow a lot more for your project.

There is a pitfall, however. Many standard lenders will rebrand unsecured personal loans with titles like “home improvement loan.” This is not the same as a home renovation loan. These loans do not take the after-renovation value into account. They only look at the existing equity (before renovations) and base the credit on that amount. This typically results in much higher rates. When you shop for a home renovation loan, make sure not getting a rebranded unsecured loan.

How Does the Home Renovation Loan Work?

Let’s look at a home renovation loan calculation compared with a standard equity loan calculation to see how this works.

The Smith family have a home they bought three years ago:

  • Their home’s current value is $450,000.
  • They have an outstanding mortgage of $350,000. 
  • The renovations they wish to complete will cost them $200,000.
  • Their home AFTER renovations will be valued at $650,000.

Standard equity loans will normally allow you to borrow up to 80% of the home’s equity. So, in the Smith’s case, their home is currently valued at $450,000. If we subtract their outstanding mortgage of $350,000 from the value, that means there’s $100,000 equity. 

80% of $100,000 = $80,000.

If the Smith’s choose a standard equity loan, they will only be able to borrow $80,000. This won’t even cover half of the renovation costs.

Now let’s look at the difference in the amount when we take the home’s after-renovation value into account:

The after-renovation value of the home will be $650,000. If we subtract their mortgage from that, we’re left with $300,000.

80% of $300,000 = $240,000.

As you can see, the loan amount is dramatically increased. The Smiths can borrow more than enough to cover their renovation costs, making it a vastly better deal overall.

Which Type of Home Renovation Loan Should You Get?

Now you’ve seen the figures, you may feel ready to jump up and get a home renovation loan. To make matters slightly more complicated, however, four types of home renovation loans are available. They all differ slightly from one another. Here’s the rundown of what’s available:

RenoFi Home Equity Loan

This type of loan works for both new and existing homeowners and is generally considered the best and least complicated option. 

The RenoFi loan is the only option that doesn’t require an inspection and draw schedule process to disburse the funds to the contractor. This makes the process a lot simpler. It’s also the only type of loan that doesn’t require homeowners to refinance. They can keep their existing mortgage rates and remaining repayment time-frame.

Single-Close Construction To Permanent Loan (CTP)

This type of loan is for construction and replaces your existing mortgage with a new permanent first mortgage. It’s similar to a cash-out refinance, the difference being that it is based on the after-renovation value.

Money is paid directly to the constructor, approved via the bank performing on-site inspections. Because this is a refinance option, rates tend to be a bit higher than the RenoFi option.

Fannie Mae Homestyle Loan

Fannie Mae is a government-sponsored agency that allows you to borrow up to 95% equity. The downside is that rates tend to be a bit higher than if you used a private bank. Private mortgage insurance is also required if you do decide to borrow over 80% equity.

Since this type of loan is a refinancing option, the closing fees and other fees are on the high side.

FHA 203K (Full)

These types of loans work exactly the same as the Fannie Mae option except that it’s a different government-sponsored agency.

This option has the lowest credit score requirements, so it’s the easiest to obtain. The downside is that this option tends to carry the highest fees.

The bottom line is that whenever you’re considering high-cost home renovations, you should look at taking out a specific home renovations loan. Not only will you be able to borrow far more than a standard equity loan, but you will also enjoy the lowest possible rates for that type of loan.

When looking at the different loans available to you, remember to check they’re based on the after-renovations value of the home. It’s also essential to compare the fees and rates with all the options to ensure you’re paying the lowest overall.

Finally, enjoy your home renovation project safe in the knowledge you have enough in the bank to cover them.

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