How do renovation loans work?

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A home renovation loan gives homeowners access to the funds they need to renovate their home. These home improvement loans can take the form of mortgages with built-in fixer-upper financing or personal loans. Depending on the type of loan you get, you may need to show that the money was spent on the home or paid to a contractor.

How do renovation loans work?

If you’re buying a home that needs repairs, there are several loan options available. How a renovation loan works depends on the type of financing you choose. Popular home renovation loan options include the following programs:

Fannie Mae HomeStyle®: The Fannie Mae HomeStyle® loan is a one-time loan that includes the cost of home repairs in the total loan amount. This loan can be used for repairs that a surveyor needs or changes that the homeowner wants to make, and it can be used to pay for both structural and cosmetic repairs.

This loan appeals to borrowers because they only have to deal with one loan, one monthly payment, and lower interest rates that cover both the purchase price and repair costs. You can choose either a 15 or 30 year mortgage term, as well as adjustable rate options. With a HomeStyle® Mortgage, your final loan amount is based on the projected value of the home after repairs are complete. The Fannie Mae HomeStyle® Loan is a good choice for a buyer with excellent credit who has access to competitive interest rates.

FHA 203(k): This government-backed loan is similar to HomeStyle®, but is open to buyers with lower credit ratings. This is usually the more expensive option of the two, since FHA mortgages have higher mortgage insurance premiums for borrowers who request smaller down payments. These mortgages have an upfront fee that is included in the total amount of the loan.

FHA 203(k) loans are divided into full and optimized options, and the type you need depends on the condition of your property. The FHA 203(k) Full Loan is for a primary residence that needs serious or significant repairs, while the Streamline Loan is used to cover minor repairs totaling less than $35,000.

EZ “C” conventional: This loan can be used with traditional mortgages for non-structural home repairs that add value to the property. It covers both appraiser-requested and borrower-selected renovations.

Jumbo renovation: A jumbo home renovation loan is just like the EZ “C” conventional, but it is used for higher priced homes that are not covered by other home repair loans. Jumbo home improvement loans can be used for projects requested by an appraiser or for repairs the borrower wants to make. Repairs don’t have to be structural and add value to the home.

USDA Rural Home Development Loans: The USDA offers funds through its rural development program to help homebuyers secure safe and decent housing. This financial support can be used to cover new appliances, foundations, siding, roofing, windows, plumbing, electrical improvements and other necessary health and safety upgrades. Program eligibility is based on income (up to 50% of area median income) and rural location.

If you can’t afford to pay for your renovations out of pocket, a home renovation loan isn’t your only option. You can also opt for a home equity loan or line of credit (HELOC), which are cheaper than personal loans. This is a preferred option if you have some equity in your home but less than outstanding loans. The difference between the two is that a home equity loan is a lump sum with a fixed interest rate, while the HELOC’s variable interest rates fluctuate with mortgage interest rates.

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When should you consider a home renovation loan?

You should only consider borrowing money to renovate your home if you are confident that the project will either reduce your long-term costs or increase the value of your property. Some home renovation projects can increase your property value by more than you spend on renovations. Attic insulation, basements, bathrooms and front door remodeling are high on the list for valuable repairs. If you’re hoping to improve the value of your home before selling it, make sure you put your money where it counts.

It’s worth considering a home renovation loan if a repair will save you money in the long run or make your home safer. Projects in these categories include roof repairs, new siding, and updated windows to keep your home weatherproof and energy efficient.

One of the most important steps in deciding on a renovation loan is knowing the risks and what to look out for. First, check your equity. The risk of default on a home improvement loan is greater when you have less money invested in your home.

Another mistake is investing too much in your remodel. You don’t want the improvements to make your home overly expensive compared to similar properties in your neighborhood. Be aware of the upper range of home sales prices in your area, or you might find that you’ve actually damaged your home’s marketability by pushing it past buyers’ expectations.

Finally, do not rush with the renovation. Meet with several lenders, know the interest rates available, and remember that remodeling is often more expensive and time-consuming than you originally thought. You should make sure your finances can handle the burden of another home loan.

Alternatives to a home renovation loan

If you have a very healthy credit rating and have a lower-cost project in mind, you can use a credit card with an interest-free promotional period as an alternative to a full renovation loan. Isolating your project expenses on a separate credit card makes it easier to separate those expenses from your usual expenses, while an interest-free offer minimizes borrowing costs. Just remember that it can be easy to overspend with a credit card, so make sure you use it responsibly and can pay back the balance quickly.

There’s also the cash-out refinance option, where you refinance your current mortgage to a higher loan amount and use the extra money for a renovation. This choice can make sense if you have at least 20% equity in the home, good credit, and low interest rate options available in the market. Before you decide to refinance, take a close look at current interest rates, lenders, and how much equity you have in your home.

The best choice for you will vary significantly depending on your situation. If you want to repair your new home right away, the lower interest rates and closing costs of a home renovation loan make the most sense. If you already have equity in your home, you can take advantage of a strong market with a home equity loan to increase the value of your home. Lines of credit or cash-out refinancing are worth considering when interest rates are low and your credit rating is healthy.

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