When it comes to home-renovation projects, you might feel completely overwhelmed. Not only do you have to make dozens of decisions regarding the design aesthetic, but you also need to find the money to afford such a large project. Odds are, you don’t have thousands of dollars just sitting around, so you might need to secure financing for your home improvement project. Two of the most common ways to finance a home renovation include taking out a construction loan or a HELOC.
What Is a Construction Loan?
“Construction loan form on a wooden table” licensed under CC BY 2.0 via Flickr by wuestenigel
A construction loan is basically what you think it is, which is a loan for certain home construction or home-improvement projects. It was originally intended for builders to turn a bare plot of land into a beautiful new home, but it’s expanded over the years to include homeowners. With this type of short-term loan, you, the lender, and the contractor arrange a construction schedule in advance. The lender ends up paying the contractor directly via structured payments during the construction process. Within the construction loan sector, there are several types of loans available:
- Construction-to-permanent loans: Typically used for new construction, this type of loan has you making payments only on the interest during construction. Once construction ends, the loan automatically converts into a mortgage. You’ll save on closing costs with this type of loan because it only involves one closing.
- Construction-only loans: Often called a stand-alone loan, this type of loan is also used for new construction. However, you pay off the loan once construction ends. You either pay off the loan in cash or take out a mortgage.
- End loans: For end loans, the builder finances the construction project and you use a mortgage to buy directly from the builder. This option, which is typically available for new construction, is often used within subdivisions or communities that work with the same builder.
- Renovation construction loans: With this loan, you’re looking to renovate a current residence. You can either convert this loan into a mortgage once the renovation is done or you can pay it back as a separate loan.
To qualify for a construction loan, you present the lender with a detailed timeframe and budget for the project. Since lenders aren’t focusing on the equity in the home, your credit history comes into play. Having a well-maintained credit score, knowing your repayment plans, and possessing an ideal debt-to-income ratio will help your case.
What Is a HELOC?
Also known as a second mortgage, a HELOC (home equity line of credit) is revolving funding that gives you access to the equity in your home. Since these loans are secured by your home’s equity, they’re often bolstered by competitive interest rates. Unlike a construction loan, a HELOC doesn’t have different types but it does have two phases in which you make payments:
- Draw period: For the initial timeframe, which is about five to 10 years, you have a maximum line amount. This means you have a total monetary amount that you can borrow. During this time, payments are flexible and you can opt to make interest-only payments if you desire, but you can also make payments toward the principal.
- Repayment period: Once the draw period ends, you pay back the money during this phase. Depending on the lender, you have between five and 20 years to pay off the remaining balance.
Typically, you can borrow up to 80 to 85% of your home equity. For instance, if your home has a mortgage of $400,000 and your home is now worth about $480,000, you should be able to secure a HELOC of approximately $70,000.
Pros and Cons of a Construction Loan and HELOC
If you’re on the fence about a HELOC or construction loan, it’s important to look at the pros and cons of both. Ultimately, the decision depends on the plans you have for the money.
Construction Loans Pros and Cons
With a construction loan, the amount of money you could qualify for depends on the cost of the project and not your home’s value. If you haven’t built up a significant amount of equity in your home or want to complete a project that’s worth more than the equity in the home, this might be an ideal option. It’s a solid choice for smaller projects or a series of incremental ones. Also, since a construction loan has a shorter repayment term, that equals lower long-term interest costs.
On the other hand, a construction loan has minimal flexibility if you have unexpected costs. You should also expect to pay higher interest rates than you would with a secured loan. With a construction loan, you are required to refinance your home, so if you’ve locked in an outstanding interest rate when they were at record lows, you’ll lose that fantastic interest rate.
HELOC Pros and Cons
A HELOC works well if you’re seeking flexibility for your renovation project and you don’t have a contractor secured or a definite schedule. For instance, if your home remodel has a long timeframe with several payment points, this option might work best for you. Also, unlike a construction loan that must be used for a specific home project, a HELOC can be used for just about whatever you want. It also tends to have a more competitive interest rate because it’s a secured loan. However, the interest rate might change during specific intervals during the length of the HELOC.
Although long repayment terms allow you to keep the payments low, the long-term costs are often higher due to the longer repayment timeframe. The amount of money you qualify for with a HELOC is based on the equity in your home, so you might not even know how much you qualify for until you begin the process. It’s also important to not default on your HELOC because you could put our home at risk of foreclosure.
If you’re looking to make home improvements, consider taking out either a construction loan or HELOC. The team at Titan Funding can help you determine which option works best for your needs and budget. Reach out to us via our secure online messaging system, and a knowledgeable team member will get back to you promptly.