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7 Must-Know Tips for Taking Out a Renovation Loan

7 Must-Know Tips for Taking Out a Renovation Loan

Each year, US homeowners spend $400 billion on residential renovations and repairs.

Remodeling allows you to tailor your home based on your budget, lifestyle, and family’s needs. However, renovation costs can add up quickly.

Most of us don’t have the cash in hand that it tasks to pay for home construction, which is where home renovation loans and financing come into play.

Wondering how to take out a renovation loan?

If you’re feeling overwhelmed with financing options for your latest renovation project, keep reading for seven tips that should help.

The Case for Renovating Your Home

Because there aren’t enough affordable homes on the market, this is a great time to choose to renovating your existing home instead of buying a new one.

It’s tough to find an entry-level home these days, whether new or lived-in. Most increases in available housing inventory have been in luxury homes.

Entry-level new home construction is also on the decline. They’re often under 2,000 square feet and tend to cost between $200,000 and $400,000. Upscale offerings can be as large as 4,500 square feet and can cost more than $400,000.

Faced with facts like these, it makes perfect sense to fix up your existing home rather than living beyond your means in a new home that doesn’t check all of your boxes.

1. Carefully Consider the Size of Your Loan

When shopping for a home renovation loan, remember that more money isn’t necessarily a good thing.

If you invest too much money into your renovation project, you may over-invest in your home or borrow more than you can pay back in an appropriate amount of time.

Before taking out a loan, check your equity. Do you have less money invested in your home than what you owe? If so, you risk defaulting on a home renovation loan.

You must also assess the value your renovations will add to the home. It’s essential only to borrow what you need to make improvements that reduce long-term costs and increase the value of your home. If you make smart financing additions, you will easily earn your money back over time.

For example, if you increase your home’s value, you can list your house at a higher price point when you sell.

Keep in mind that the amount of money you’ll be able to borrow is based on several factors, including how much money you make, how big of a downpayment you can provide, your FICO score, and the loan-to-value ratio.

2. Start Saving Money

Lenders view construction loans as riskier than traditional mortgages, which is why they often demand a downpayment of a minimum of 20%—and sometimes more.

You should save for your downpayment and reserve some cash to cover unexpected building or repair expenses that often rear their ugly heads during the construction process.

If you’re trying to develop ways to save money, consider reducing or cutting out a bad habit such as impulse buying or getting takeout often.

3. Choose the Right Builder

Before beginning the home construction loan process, finding a builder that is available for your project is vital. Nothing is worse than securing the funds and delaying the remodel because you can’t find a contractor that suits the project.

Plus, it’s always best to convince your lender that there’s little risk. Choosing a home builder with a solid reputation for steady, quality work can work in your favor.

It’s up to you to find experienced, qualified contractors to do the work. You’ll also have to have the right insurance and oversee the work.

4. Make a Plan

Most lenders won’t approve remodeling loans without a detailed plan for the project in hand. They want to know what you intend to do with the money you borrow and when you’ll use it.

Don’t visit any potential lender without your project plans, specifications, and signed contracts that include clear start and end dates. Your renovation plans may determine the type of loans you’re eligible for.

5. Examine Your Eligibility

Before you dive into your first renovation loan application, consider your eligibility to see which loans you may qualify for.

Scrutinize your credit report to identify on-time credit card and bill requirements or any errors. If there are discrepancies, tackle those right away because it can hurt your chances of approval and increase the chance of higher interest rates.

Most lenders will accept a FICO score of 620 or higher, but some may allow a score as low as 580. In all cases, the higher your credit score, the lower your interest rate will be.

Lenders also look into your debt-to-income ratio to qualify you for a loan. You can calculate this percentage by dividing your total amount of monthly debts (i.e., car loans, mortgage, credit card debt, etc.) by your monthly gross income.

Most home equity lenders require that a borrower’s debt-to-income ratio should be no higher than 43%, a recommendation from the Consumer Financial Protection Bureau.

6. Understand Your Loan to Value Ratio

To determine how much a lender will loan you for a renovation, they will use a loan-to-value ratio (LTV).

LTV is the percentage of the appraised value of a home, and a normal LTV is 80%. This would equal $120,000 for a home worth $150,000.

Lenders will subtract your mortgage balance from the LTV to determine the maximum amount you’ll borrow. Say your mortgage balance is $60,000, the maximum amount of money you can borrow is $40,000.

However, if your FICO score is higher, the lender may base your loan on a higher percentage. If your score is low, it might only be 70% or 75%. Ask the lenders you’re considering what their LTV requirements are for home renovation loans.

7. Weigh Your Loan Options

When it comes to how to take out a loan for a remodel, there are several ways to get the funding you need. We’ll go over a few to help you make an informed decision on which loan is right for you.

Cash-Out Refinance

A cash-out refinance allows you to refinance to a new mortgage loan and carry a higher balance than what you currently owe.

The money you receive from this transaction becomes home equity that you can use to fund your renovation.

FHA 203(k) Rehab Loan

The benefit of an FHA 203(k) rehab loan is that you can bundle your home improvement costs and mortgage into a single loan. You don’t have to apply for two separate loans if you’re building new construction.

These loans are backed by the United States government, which means you can take advantage of a low down payment and stand a chance with lower credit.

Home Equity Loan

Taking out a home equity loan (HEL) means you’re borrowing against any equity you’ve built up in your home over time. Lenders calculate your equity by determining your home’s value and subtracting your mortgage’s outstanding balance.

HELs are different from cash-out refinances, as they don’t pay off your current mortgage.

Home Equity Line of Credit

You can also finance improvements with a home equity line of credit (HELOC), which is similar to the HEL discussed above.

A HELOC works more like a credit card. You can borrow from a line of credit up to a pre-approved maximum amount. Once you’ve paid it back, you can borrow from it again.

Interest rates for HELOCs are adjustable, unlike those for HELs. However, interest is only due on your balance and not on the entire credit line.

HELOCs give you the flexibility to withdraw money when you need it, and the credit line remains available for up to ten years.

Personal Loan

If you don’t have tons of equity in your home, consider an unsecured personal loan to finance your remodel.

In this scenario, you won’t use your home as collateral, and you can obtain funds much faster than other lines of credit.

Rather than heading directly to the big banks, consider smaller lenders like Plenti to see what they have to offer.

Credit Cards

If your project is small, you may consider putting the construction expenses on your personal credit cards.

Most experts recommend against this due to high interest rates and the risk of unforeseen circumstances during a remodel.

However, if you can apply for a card with a 0% introductory rate, it might be worthwhile, especially if the repairs are critical to the structure or safety of your home.

While they’re okay to use in an emergency situation, you shouldn’t depend on credit cards for long-term financing.

Time to Start Looking for a Renovation Loan

After reading these tips for taking out a loan, do you feel less overwhelmed about your potential renovation loan options?

With so many avenues to explore, you’re sure to find a loan that fits your budget, needs, and project plan.

For more helpful content, please continue to browse our archive.

Written by Shilpa

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