How Do Home Renovation Loans Work?

Some properties may need a little more work and improvement than other properties before they can be considered a dream home for residents. This is where renovation loans come in and help out property owners in need.

Through a home renovation loan, homeowners can gain access to funds needed to repair their home. Renovation loans can be granted in the form of mortgages or personal loans. Based on the type of loan you receive, you may need to provide proof that the money was actually spent on renovations or paid to a contractor. How a home renovation loan works largely depends on the type of financing for which you decide to apply. Here are some popular home renovation loan options:

• Single-close loan: This loan is also called a construction-to-permanent loan. It is normally used when you buy a piece of land and build your own house on it. The loan covers both the cost of purchase and the cost of repairing the property, and can convert to a permanent financing upon the completion of construction. For example, the Fannie Mae HomeStyle loan is a single-close loan. If you have a good credit score, the Fannie Mae HomeStyle would be a good choice and offers an attractive interest rate. The HomeStyle loan can be used for all kinds of renovation projects, but requires the use of a certified contractor.

The benefit of a single-close loan is that property owners only have to deal with one loan and make a single payment each month. It also offers lower interest rates.

• FHA 203(k): This is a government-backed loan and is similar to the Fannie Mae HomeStyle loan, except that it accepts borrowers with recovering credit scores. For this reason, it is also more expensive. If a homeowner applies for this loan with a small down payment, the loan will charge a higher mortgage insurance premium. It can also be used for a variety of renovation projects, big or small. An upfront fee is required and included in the principal amount of the loan.

FHA 203(k) loans are divided into two options, FHA 203(k) Full Loan and FHA 203(k) Streamline Loan. The Full Loan is designed for property owners making large-scale, major repairs on a primary residence. The Streamline Loan, on the other hand, is designed for smaller repairs whose costs do not exceed $35,000. Depending on how much work your property needs, you can choose between the two options.

• Home equity loan: This is essentially a second mortgage taken on your property, and is a one-time deal. You receive a lump sum and will pay the loan over time with a specific interest rate and same amount of loan payment every month. However, the amount you can receive under the home equity loan is based on the current value of your property, and not the value of your property assuming the renovation is completed. Since this is also a mortgage, if you default on the loan payment, your property may be foreclosed.

• Home equity line of credit (HELOC): This is similar to the home equity loan, with a major difference on how the loan works. You can imagine HELOC as your credit card. You are given a specific amount of credit which you can draw from when you need money. The interest amount depends on the actual amount of money you draw from your line of credit. HELOC is suitable for homeowners who have several large payments they need to pay over time.

• USDA Rural Development Home Repair Loans: This is a loan offered by the USDA through its Rural Development program. It is intended to enable homeowners to obtain safe and decent houses. The loan can be used for necessary improvements due to health and safety concerns, such as new foundations, roofing, appliances, siding, plumbing, windows, and electrical improvements. This is an income- and location-based program.

• Cash-out mortgage refinance: This allows homeowners to refinance their existing mortgage and receive a higher amount of mortgage than their first one. Property owners will receive the difference in cash, which can then be used for property renovation. Please note that you will need at least 20 percent of equity in your property to be eligible for this cash-out refinancing, with the maximum loan amount equal to the available equity in your property.

• Personal unsecured loan: Lastly, you can always apply for an unsecured commercial loan to finance the renovation. However, unsecured loans usually have a higher interest rate.