How Do Home Renovation Loans Work?

A home renovation loan gives homeowners access to funds needed to fix up their home. These renovation loans can come in the form of mortgages with built-in fixer-upper funding or personal loans. Depending on the type of loan you receive, you may need to show proof that the money was spent on the house or paid to a contractor.

How Do Home Renovation Loans Work?

If you’re buying a home that needs repairs, there are multiple loan options available. How a home renovation loan works will depend on the type of financing you decide to apply for. Popular home renovation loan options include the following programs:

Fannie Mae HomeStyle®: The Fannie Mae HomeStyle® loan is a single-close loan that includes the cost of home repairs in the overall loan amount. This loan can be used for repairs that an appraiser requires, or for changes 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 the cost of repairs. You can select either a 15- or 30-year mortgage term, along with adjustable-rate options. With a HomeStyle® mortgage, your final loan amount is based on the projected value of the home after the repairs are completed. Fannie Mae’s HomeStyle® loan is a sound choice for a buyer with top-notch credit who has access to competitive interest rates.

FHA 203(k): This government-backed loan is similar to HomeStyle®, but it’s open to buyers with lower credit scores. This is usually the more expensive option of the two because FHA mortgages have higher mortgage insurance premiums for borrowers who apply with smaller down payments. These mortgages have an upfront fee that's included in the overall principal of the loan.

FHA 203(k) loans are divided into full and streamline options, and the type you need will depend on the state of your property. The FHA 203(k) Full Loan is intended 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"onventional: This loan can be used with conventional mortgages for non-structural home repairs that add value to the property. It covers both appraiser-required and borrower-selected renovations.

Jumbo Renovation: A jumbo renovation loan is just like the EZ "C"onventional, but it’s used for higher-priced homes that aren’t covered by other home repair loans. Jumbo renovation loans can be used for projects required by an appraiser or repairs the borrower wants to make. Repairs must be non-structural and add value to the home.

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

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

When Should You Consider a Home Renovation Loan?

You should only consider borrowing money to renovate your home if you're 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 a greater amount than what you spend on renovations. Attic insulation, basements, bathrooms and front door remodels top the list for valuable repairs. If you’re hoping to improve the value of your home before selling, make sure you’re putting your money where it counts.

It's worthwhile to look into home renovation loans if a repair will save you money in the long run, or make your home a safer place. 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 home renovation loan is knowing the risks and what to watch out for. First of all, check your equity. There’s a bigger risk of defaulting on a renovation loan when you have less money invested in your home.

Another mistake is investing too much in your remodeling. You don’t want the improvements to make your house overly expensive when compared to similar properties in your neighborhood. Be aware of the upper range of home sale prices in your area, or you could find that you've actually damaged the marketability of your home by pushing it past buyer expectations.

Finally, don’t rush to renovate. Meet with several lenders, know the available rates, and remember that remodels often end up being more expensive and time-consuming than you might originally assume. You should ensure that you finances can handle the burden of another home loan.

Alternatives to a Home Renovation Loan

If you have very healthy credit and a less expensive project in mind, you can use a credit card with a promotional no-interest period as an alternative to a full renovation loan. Isolating your project costs on a separate credit card will make it easier to keep those expenses separate from your usual spending, while a no-interest offer will minimize the cost of borrowing the money. Just remember that it can be easy to overspend with a credit card, so make sure you’re confident you can use it responsibly and repay the balance quickly.

There's also the cash-out refinancing option, which involves refinancing your current mortgage at a higher loan amount and using the extra cash for a renovation. This choice might make sense if you have at least 20% equity in the home, a good credit score and low interest rate options available in the market. Look carefully at current rates, lenders, and how much equity you have in your home before choosing to refinance.

The best choice for you will vary significantly depending on your situation. If you want to make home repairs on your new home right away, the lower rates and closing costs of a home renovation loan make the most sense. If you’ve already built up some equity in your home, you can take advantage of a strong market with a home equity loan to increase the value of your home. Credit lines or cash-out refinancing are worthwhile considerations when interest rates are low and your credit is healthy.