Renovating your home or making much-needed repairs can make it more functional for your family and increase your home value. But it’s also a costly endeavor that could ding your cash reserves. Or you can take out a home improvement loan to hold on to more of your hard-earned money and repay what you borrow over time.
Here’s what to know about home improvement loans and key benefits and drawbacks to consider before deciding if it’s right for you.
Can You Get a Mortgage for Home Renovation?
There are several mortgage options to choose from to cover home renovation costs. More on each of these shortly.
What is a Home Improvement Loan and How Does It Work?
As the name suggests, a home improvement loan is a form of financing designed to cover the cost of renovations and repairs on your property. Loan proceeds are disbursed in a lump sum and payable over a set period in equal monthly installments, assuming the interest rate is fixed.
There are both unsecured and secured options – the latter requires collateral for approval, and you could lose your home to foreclosure if you’re unable to make loan payments.
Are Renovation Loans a Good Idea?
A renovation loan could be ideal if you qualify for a loan with competitive terms and can comfortably afford the monthly payments. Keep in mind that you could get a better deal with a home equity mortgage product or home loan that combines the purchase price with renovation costs into a single loan.
Securing a Mortgage for Home Renovation
A home renovation mortgage may also be ideal if you want to look beyond a standard installment loan. They come in the form of primary and second mortgages. Primary mortgages offer the convenience of a single loan that combines purchase and upgrade costs. Second mortgages are taken out in addition to your primary home loan, giving you two monthly housing payments.
Types of Mortgage for Home Renovation
Below is a closer look at mortgage options to renovate your home.
Home Equity Loans and HELOCs
Both act as second mortgage loans and allow you to convert a percentage of your home equity into cash. Most lenders cap home equity loans and home equity lines of credit (HELOCs) at 85%, but this figure could be smaller depending on your financial situation.
Home equity loans come with a fixed interest rate. Loan proceeds are disbursed in a lump sum and payable in equal monthly installments over a set period.
However, HELOCs are revolving lines of credit that operate like credit cards. You get access to a line to pull from as needed during what’s referred to as the draw period. Interest is only payable on the amount you borrow, and the rate is variable. So, your monthly payments will fluctuate as market conditions change.
The primary draw of home equity loans and HELOCs is the ability to access cash without having to refinance your current mortgage. This is beneficial if you have favorable terms, but it also means you’ll have an additional monthly housing payment to account for.
Cash-Out Refinancing
A cash-out refinance is another option to tap into your home equity to cover renovation costs. When you exercise this option, you replace your current mortgage with a new one for a higher amount. The difference between the two loans is the cash you receive at closing, and it’s based on the amount of equity you have in your home.
To illustrate, assume your home is worth $400,000, and you owe $250,000 on the mortgage. You inquire about a cash-out refinance, and the lender agrees to let you pull out 80% in equity.
If you agree with the terms and decide to move forward with the transaction, the new lender will give you a new loan of $320,00 and pay off your existing loan of $250,000. And you’ll receive the difference of $70,000 in cash.
Here’s a breakdown of the calculations:
- $400,000 * .80 – $250,000 = $70,000 (amount of accessible equity)
- $250,000 + $70,000 = $320,000 (new loan amount)
Fannie Mae HomeStyle Renovation Loan
It is a renovation mortgage that lets you combine the purchase price of the home, closing costs and renovation costs into a single mortgage. You’re not limited to using it to buy a different home than you currently have. Instead, you can use it to refinance your existing property.
You’ll need a credit score of 620 or higher, and the maximum allowable debt-to-income (DTI) ratio is 45%. And the amount you can borrow is capped at 75% of the home’s “as-completed” appraised value.
Freddie Mac CHOICERenovation Loan
The Freddie Mac CHOICERenovation Loan is also intended to help borrowers purchase or refinance and include renovation costs into the mortgage. Like the HomeStyle Renovation product, you can finance up to 75% of the home’s post-renovation value. (A limit of the lesser of 50% or $50,000 applies to manufactured homes).
Borrowers typically need a minimum credit score of 620 and a DTI not exceeding 43%.
FHA 203(k) Loan
The FHA 203(k) Loan program is backed by the federal government and provides funds for purchasing a home and the subsequent renovation. It is particularly effective for those looking to purchase a home that needs significant repairs.
You could be eligible with a credit score as low as 580 and a 3.5% down payment. If your credit score is on the lower end, a 500 credit score could work if you can make a 10% down payment. The maximum preferred DTI is also 43%, but the lender may be willing to make an exception if there are other compensating factors in your financial profile.
VA Renovation Loan
If you’re a veteran, active-duty service member, or an eligible spouse, you may qualify for a VA Renovation Loan, which allows funding for both home purchase and improvement with no down payment.
The VA does not set a minimum credit score for its loan products. However, a 640 or higher is preferred by most lenders, along with a DTI of no more than 41%.
USDA Renovation Loan
Lastly, the USDA Renovation Loan is available to those in rural communities. It can finance home purchases as well as renovations. Also, it doesn’t require a down payment, though it does have geographic and income restrictions.
Aim for a credit score of 640 or higher and a DTI of no more than 41% before applying. Remember, guidelines may vary by lender, but adhering to these thresholds gives you the best chance of getting approved for a USDA Renovation Loan.
The Pros of a Mortgage for Home Renovation
There are several perks to taking out a mortgage to renovate your home.
Enhancing Your Property’s Value
Your home’s value could increase significantly, depending on the scope of home renovations. This is a major upside if you plan to sell your home soon and want to maximize your profits.
Improving Your Living Space
The functionality of your home is paramount, especially if you plan to stay but for some time. Making the right upgrades or repairs could also improve your quality of life during the time spent at home.
Avoiding the Need for a Larger Loan
It can be challenging to get a traditional home improvement loan for a large amount. But if you have a sizable amount of equity, a mortgage could unlock more funding opportunities.
Build Your Credit
Timely payments on a home renovation mortgage can positively affect your credit rating. As your credit score continues to improve, you may qualify for more attractive terms on future loan products.
The Cons of a Mortgage for Home Renovation
You should also consider these downsides when evaluating if a mortgage for home renovation makes financial sense.
Higher Fees
Mortgages come with closing costs – typically between 2% and 5% of the loan amount. Depending on the lender, you may have the option to roll them into the loan or secure a no-closing-cost mortgage. If you choose the latter, you’ll likely get a higher interest rate to account for these costs.
Higher Interest Rates
You could also get a higher interest rate compared to that of a traditional mortgage. This is especially true with second mortgages, as the risk of default is higher. Unfortunately, a slight increase in the interest rate could mean a steeper monthly payment and several thousand more in interest paid over the life of the loan.
Some are Secured
Home renovation mortgages and second mortgages used for home improvements are secured. They use your home as collateral, which means defaulting on the agreement could lead to foreclosure. So, you should only take out this type of mortgage if you are certain you can afford to make timely monthly payments.
How to Qualify for a Mortgage for Home Renovation
The lending guidelines vary by mortgage type. That said, lenders will assess your credit score, income stability, employment history and debt-to-income (DTI) ratio to determine if you’re a good fit for a home loan.
A credit score of at least 620 is preferred, but it could be lower if you’re seeking a government-backed mortgage. Your DTI, or the percentage of your monthly gross income used to cover debt obligations, should not exceed 43%. Again, there is some flexibility here as well with select loan products or if there are other compensating factors.
Lenders also want reassurance that you have stable employment and the means to make timely monthly mortgage payments. If there is any doubt, you could be denied financing.
Documents Required for Application
When you apply for a renovation mortgage, the lender will request the following documents:
- Proof of income, including two most recent pay stubs, W-2 forms, bank statements and tax returns
- Contractor bids or detailed proposals from licensed contractors that detail the scope of work and associated costs
A credit check is also required, as your credit score heavily influences the rate you’ll receive on the loan. The lender also orders a professional appraisal to get an accurate estimate of the home’s current value and projected value following renovations.
Be sure to gather these documents in advance to avoid delays in processing your application. Also, note that this list may not be complete, so it’s worth inquiring with the lender to confirm what you’ll need.
Steps to Apply for a Renovation Mortgage
When you’re ready to apply for a new home loan to cover renovation costs, here’s how to move forward:
- Step 1: Research lenders. Compare renovation mortgage products from at least three lenders to find the best rates and terms.
- Step 2: Get pre-approved. Secure a loan pre-approval to gauge how much you can borrow and with what terms.
- Step 3: Find a contractor. Choose a licensed, reputable contractor with extensive experience completing jobs you’re looking to have done.
- Step 4: Request a bid. Ask your contractor for a detailed bid that outlines the renovation plan and includes cost estimates.
- Step 5: Apply for a loan. Formally apply for a loan with the lender you select and submit the contractor bid along with the supporting documentation needed to get a lending decision.
- Step 6: Get an appraisal. The lender will order an appraisal to get a concrete idea of the home’s value before and after the renovation is complete.
- Step 7: Seal the deal. If approved, attend the closing meeting to sign the agreement and finalize the loan.
Conclusion: Making the Right Decision for Your Home Renovation
Choosing the right type of home improvement loan to fund your renovations comes down to your financial situation, creditworthiness and specific needs. You’ll also need to evaluate the specifics of each loan option and weigh the pros and cons to decide which is best. Most importantly, research lenders and compare loan quotes to ensure you get the best deal on financing.
