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How A Home Renovation Loan Works

Hanna Kielar5-minute read
October 06, 2022

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Whether you’re making necessary repairs or improvements to a home, or buying a fixer-upper, you could probably use some extra funds to make your vision a reality. Fortunately, a certain kind of loan – known as a renovation loan – is designed specifically for these types of home projects.

Let’s look at how renovation loans work and what sets them apart from your standard home improvement loan.

What Is A Renovation Loan?

A renovation loan provides funding for homeowners or buyers wanting to make extensive repairs or upgrades to a property. Unlike other types of loans, many renovation loans are based on a home’s after-repair value (ARV), or its estimated value once renovations are complete.

While similar to a construction loan, a renovation loan is used for home upgrades or adding onto an existing home, rather than building one from the ground up.

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How Does A Renovation Loan Work?

Typically, a renovation loan is a mortgage – used for purchasing or refinancing – that includes additional funds for renovations.

Lenders use homes’ ARV to determine what loan amount borrowers qualify for, as opposed to basing the loan on a home’s current value. This can dramatically increase the amount you can borrow, especially if your planned renovations will add value to your home.

Renovation loans are commonly used for:

Depending on the appraised future value of your home, you could also qualify for a good interest rate since lenders typically base this off of your loan-to-value (LTV) ratio, which compares the loan amount you want with your home’s value (or future value, in this case).

Home Improvement Vs. Renovation Loans

The terms “renovation loan” and “home improvement loan” are sometimes used interchangeably, but they’re not technically the same. Home improvement loans are generally used for more minor upgrades than renovations typically cover, and therefore offer lower loan amounts.

Examples of common home improvement loans include:

  • Personal loans: Unsecured personal loans are available for almost anything you need cash for, including home improvements.
  • Home equity loans: A home equity loan lets you borrow against the equity in your home to use it as cash, but your home must serve as collateral.
  • Home equity lines of credit (HELOCs): Similar to a home equity loan, a HELOC allows you to borrow from a credit line based on your equity.
  • Cash-out refinancing: A cash-out refinance allows you to refinance your mortgage and turn your equity into cash.

If the upgrades you’re making don’t require a complete renovation, or you don’t need to borrow more than $50,000, see if you should get a personal loan instead. Renovation loans are best-suited for homeowners who don’t yet have a lot of equity in their home.

Loan Options For A Home Renovation

How a home renovation loan ultimately works depends on the loan you choose. Here are some common options for renovation loans, and the pros and cons of each.

Fannie Mae HomeStyle® Renovation Mortgage

A HomeStyle® Renovation mortgage allows borrowers to buy or refinance a home and provides the cash needed for renovations. An approved contractor is required to qualify for the loan, as the funds for renovations are kept in escrow and only to be withdrawn by the contractor. This helps to prevent fraud or a homeowner from using the funds for non-renovation purchases.

Pros

  • A HomeStyle® Renovation mortgage can be used to renovate various types of properties (single-family, townhome, condo, etc.).
  • A down payment on this loan can be as low as 3% of the home purchase price.
  • Renovation costs are rolled into your monthly mortgage payment.

Cons

  • Renovation costs can’t exceed 75% of the home’s ARV.
  • Your minimum credit score to qualify is typically 620, and maximum debt-to-income (DTI) ratio is usually 50%.
  • A down payment under 20% will require purchasing private mortgage insurance (PMI).

FHA 203(k) Rehab Loan

The FHA 203(k) Rehab loan is backed by the Federal Housing Administration (FHA) and works similar to the HomeStyle® loan but is primarily used for fixer-upper homes.

Pros

  • An FHA 203(k) has low credit score and down payment requirements.
  • Borrowers may be provided temporary housing while renovations are being done.
  • Home purchase and renovations are paid for under a single mortgage.

Cons

  • A mortgage insurance premium (MIP) must be paid upfront and monthly.
  • The loan can’t be used for investment properties.
  • FHA 203(k) loans require more paperwork than most mortgages.

VA Renovation Loan

A VA Renovation loan functions like most other renovation loans and includes a lot of additional benefits for qualifying veterans or eligible surviving spouses. Like the FHA 203(k) loan, a VA Renovation loan can only be used for primary residences, and on structural repairs or upgrades that improve the safety or livability of a home. Luxury additions like a pool won’t qualify.

Pros

  • Borrowers can take out up to 100% of their home’s ARV.
  • VA Renovation loans offer a 0% down payment without requiring mortgage insurance.
  • As with other renovation loans, borrowers have only a monthly payment.

Cons

  • Borrowers must meet VA loan requirements and hold a Certificate of Eligibility (COE).
  • The maximum renovation cost amount is typically $50,000.
  • The loan doesn’t allow major structural or luxury renovations.

How To Get A Renovation Loan

First, look over your credit report. Your credit score will be your main gateway to many of your renovation loan options, and it will determine your interest rate and loan terms. A higher score will mean better deals.

Next, plan out your home renovation. What needs to be done? How much will it all cost? Having an approximate budget in mind is imperative to knowing how much you’ll need to borrow.

Finally, if you’ve ever had a mortgage, you know the drill: Shop around with different lenders, get preapproved and choose the lender who can offer you the best deal.

Alternatives To A Renovation Loan

A renovation loan won’t work for everyone’s situation, so if you’re considering alternative options, start with the examples below.

Home Improvement Loans

Getting a home improvement loan may require less strict guidelines and paperwork than a renovation loan, and plenty of options are available as well. As already noted, personal loans, home equity loans, HELOCs and cash-out refinances can all be used to finance home improvements.

Renovation loans are also better for homeowners with less equity in their homes, so if you have the equity to cash out, you might be better off with a home improvement loan. However, home equity loans and HELOCs require using your home as collateral, whereas a personal loan wouldn’t require any collateral at all.

0% APR Credit Cards

While credit cards typically have high interest rates, some card issuers offer 0% annual percentage rate (APR) introductory periods for borrowers signing up for a new card. This period typically lasts 12 – 18 months and cardholders can make interest-free payments on their balance during that period. Renovations can be expensive, though, and if you can’t pay the balance off in that time frame, you could get hit with an interest rate of over 16% for the remainder of your payments.

Emergency Funds

You could justify dipping into your emergency fund if your home requires immediate repairs for safety reasons. Just make sure you don’t drain your account completely, or you could be without a safety net for the next emergency that comes along.

Final Thoughts

With a renovation loan, you can buy a new house and pay for needed repairs. Or you can refinance and get the funds you need for upgrades – all in one package. Each type of renovation loan has certain requirements and benefits, so choose one that best suits your situation.

If a home improvement loan sounds more like what you need, get prequalified today for a personal loan with Rocket Loans℠.

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Hanna Kielar

Hanna Kielar is a Section Editor for Rocket Auto℠, RocketHQ℠, and Rocket Loans® with a focus on personal finance, automotive, and personal loans. She has a B.A. in Professional Writing from Michigan State University.