How Do Home Renovation Loans Work?

Written by Elijah BishopUpdated: 6th Jan 2022
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If you could renovate your home, what would you want it to look like? 

If you’re like most homeowners, you would want a home that is functional and expresses your style. The choice is numerous; whether it is a new roof, a terrazzo floor, a kitchen countertop, or a shower that feels like a rain forest. 

But home renovation costs can go from as little as $10 per square foot to up to $200 per square foot. The good news is that you don’t have to wait until you have the entire cash in hand before starting your home renovation.

Getting a home renovation loan can help you begin the renovation project sooner than expected. 

We’ll show you how home renovation loans work, the different types of home renovation loans, and loan eligibility requirements in the following sections. 

What Is a Home Renovation Loan?

A home renovation loan is an unsecured loan that provides you with the necessary funding to pay for a home improvement, remodeling, or repairs. Home renovation mortgages are often available in the following forms: 

Whether you’re taking out a home renovation loan to cover the cost of renovating a single bathroom or your entire house, the home renovation loan you choose can play a considerable role.

Your chosen loan program will determine your loan interest rate, loan amount, and potential monthly mortgage payments

How Do Home Renovation Loans Work?

While most home renovation loans are paid over 15 to 30 years, you do not have the same timeframe to complete your desired renovation.

One of the significant characteristics of a home renovation mortgage is that while borrowers do receive the necessary funding for their home renovation project, all the upgrades must be completed within a period of 6 months to a year from closing. 

Before applying for a home renovation loan, you must understand that the workings of a renovation mortgage differ across lenders.

But in general, you will need to find a mortgage lender that offers home renovation loans and send in a loan application. 

To get approved, you’ll need to meet the loan eligibility requirement and submit proof of your income and employment.

Then you choose a builder or contractor (must be verified by the lender) to evaluate the building and provide an estimate for the renovation project. 

Before the final approval, the mortgage lender will organize an appraisal to assign pre-renovation value and post-renovation value of the home while considering the estimates provided by your contractor.

Typically, the post-renovation or post-repair value determines how much you are allowed to borrow on your renovation loan. 

>> More: Best Home Improvement Loans

Home Renovation Loan Example

Let’s say John is buying a fixer-upper for $180,000. And the contractors’ estimate reveals that the home needs $80,000 in repairs. Below is what will happen when John approaches a lender for a loan. 

  • At closing, John will have to close for a loan that covers both the cost of buying the home and carrying the repairs. That is $180,000 for the home price plus $80,000 for the project, which equals $260,000. Most lenders will include a 10% project contingency to cover any uncertainty.  
  • Now John will need to work with the contractor to create a renovation project schedule that allows the contractor to draw funds from the escrow account to cover the cost of each project milestone. 
  • At the end of each construction week, John’s lender will send over an inspector to verify the level of the work done. Once inspected, you and your lender will sign payment paperwork to receive money for the completed and subsequent milestones. 

Types of Home Renovation Loans

Unlike a traditional home-buying mortgage, you have few available options when it comes to financing your dream home renovation project. Here’s a look at the types of home renovation loans: 

FHA 203(k) Loan

Quite similar to the Fannie Mae Homestyle renovation loan program, the FHA 203(k) Renovation Loan is insured by the Federal Housing Administration and provided by an FHA-approved lender.

One of the FHA 203(k) distinctive characteristics is that it is targeted at home buyers with poor credit scores and low-down payment amounts. Currently, there are two main types of FHA 203(k) loans:

  • Limited 203(k) loans are capped at $35,000.
  • Standard 203(k) loans are for significant rehabilitation or construction.

If you decide to opt for the standard FHA 203(k) loan, your lender will send a qualified consultant to monitor every project stage.

From the initial blueprint to the finished home. Also, this form of a renovation loan is only available to homes that are at least one year old with a renovation expense not less than $5,000. 

While the FHA 203(k) is an excellent option for homeowners with a not-so-perfect credit score, it comes with very high-interest rates, upfront, and annual mortgage insurance costs.

More importantly, FHA 203(k) loans cannot be used to finance any property that will be sold within three months.

And the total value of purchase and rehabilitation must not exceed the mortgage limit of the area. 

Jumbo Renovation Loan

Like traditional jumbo mortgages, a jumbo renovation loan is a type of renovation loan that allows homebuyers to fund the combined cost of their home purchase and renovation outside the conforming limits approved by Fannie Mae and Freddie Mac.

Jumbo loans can be used for rehabilitation required by an appraiser or requested by the borrower. 

While jumbo renovation loans can be used for basic renovations such as kitchens, swimming pools, and outdoor living spaces, they cannot address structural repair issues. It must only be used for items attached to the home to increase the value of the property. 

In addition, the maximum amount available for renovations or repairs cannot be greater than the lesser of $250,000 or 30 percent of the completed renovation value.

More importantly, jumbo renovation loans can only be used for single-unit, primary residences only. 

Fannie Mae HomeStyle®

As the name implies, Fannie Mae HomeStyle is a type of loan insured by Fannie Mae, one of the government-sponsored entities.

One of the upsides to this type of renovation loan is that it is a single close loan that includes the costs of home repairs in the overall loan amount.

That is, you don’t have to get a separate loan for the mortgage and another loan for home repairs. Getting one loan eliminates the stress of applying for multiple loans, multiple mortgage payments, and closing costs.

  • Borrowers must meet Fannie Mae’s underwriting eligibility criteria.
  • Renovations are limited to 75% of the after-repair value (ARV) or purchase price plus the project cost (whichever is less.)
  • This loan enables contractors to draw up to 50% upfront for material costs.
  • The only home appraisal needed is the initial after-value appraisal done before closing the loan.

With a Fannie Mae Homestyle loan, you have the option of choosing a 15 or 30-year loan term, along with an adjustable interest rate.

Applying for a Fannie Mae Homestyle can be an excellent option if you have a stellar credit score. 

EZ “C”onventional Loan

EZ “C”onventional loans can roll pre-planned value-adding renovations into the original loan and structure it just like a traditional loan.

This loan type can cover appraiser-required or borrower-desired renovations as long as they add value to the home over time. EZ “C”onventional loans program is designed to cater to more minor repairs that can be fixed in 60 days or less.

The cap for costs is $35,000 or 10% of the improved value. To get started, you will only need to provide 5% of the combined value.

USDA Rural Development Home Repair Loans

Issued by the United States Department of Agriculture (USDA), the USDA rural development home repair loan or Section 504 Repair Home Repair Program is designed to help rural home buyers and homeowners repair and secure decent housing. 

This home repair financial assistance can be used to cover the cost of 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. 

Do Home Renovation Loans Have Fees?

The costs and fees of a renovation loan will highly depend on the type of loan you qualify for.

Home renovation loans like the FHA 203(k) will require several fees ranging from inspection fees, title update fees, supplemental origination fees, and HUD consultant fees.

It is common across home renovation loans to spend around 1-3 percent of the total loan amount on the loan closing costs. 

Home Renovation Loan Interest Rates: Are They High or Low?

It is common for home renovation loans to come with high-interest rates compared to other types of mortgages.

This is because renovation loans are riskier for lenders since the loan amount is issued based on the home’s after-repair value.

In addition, home renovation loan interest varies and depends on the type of renovation loan you qualify for. 

On average, home renovation loan rates currently range from around 3 percent and up to 36%.

More importantly, the interest rate you receive on your renovation loan will play a huge role in determining the amount you spend on your monthly mortgage payments. 

When Do Home Renovation Loans Make Sense?

With so many ways to finance your home renovation project, it can be challenging to decide which financing method is best for you.

If you’re still on the fence on whether you should take out a home renovation loan, here are three times taking out a home renovation loan makes sense. 

Your renovation will increase the value of the property.

It is no longer news that putting money into your home could increase its resale value in the nearest future.

For example, if you took out a $10,000 loan to renovate your home’s electrical system, you might get the money or even more when you decide to sell your home.

You should only consider taking out a renovation loan if the intended repairs add to your home market value. 

Your renovation will improve your safety and quality of life.

Borrowing thousands of dollars through a renovation loan to pay for home improvements that may have little to no impact on your daily life isn’t worth it.

You should only consider a renovation loan if the home improvements increase your home safety or make your home more functional. 

Your renovation will make your home less expensive to maintain

For instance, if you have an old heating system that costs you several hundreds of dollars in utility bills, taking out a renovation loan to change it to an energy-efficient system is a great idea.

Not only does it add to your home value, but it also saves you money that would have been spent on high utility bills. 

A home renovation loan isn’t the only available option for paying for home repairs and improvements.

Today, you can take out a home equity line of credit, cash-out refinance, or even an FHA Title 1 loan. But either way, you must shop around when searching for a renovation loan and compare offers. 

What Factors Are Considered When Applying for a Home Renovation Loan

Before you dive into applying for a home renovation loan, you should consider the following factors: 

Credit Score

Like any other type of mortgage, your credit score plays a considerable role when applying for a home renovation loan.

Your credit score and credit history will determine whether your application is approved and the interest rate you qualify for.

A FICO credit score of 620 or higher will usually be needed to receive approval. However, some borrowers may allow a score of 580. The lower your credit score, the higher your interest rate will be.

Debt-to-Income Ratio

In addition to your credit score, lenders will request to see yourdebt-to-income ratio when applying for a home improvement loan.

You can figure this out by dividing the sum of your monthly recurring debts by your monthly gross income.

Most home renovation mortgage lenders will follow the Consumer Financial Protection Bureau’s recommendation that a debt-to-income ratio should not be any higher than 43 percent.

Loan-to-value Ratio

Your loan-to-value ratio is simply the amount of loan you hope to borrow compared to the appraised value of the property you want to buy.

In the case of renovation loans, lenders use the pre-renovation fair market property value to determine how much you can borrow with a home renovation loan.

The higher your property value and lower your current mortgage balance, the higher the home renovation loan you can afford. 

Most home renovation loan lenders permit a maximum combined loan-to-value (CLTV) ratio of 80% to 90%, which means you can borrow 80% to 90% of the value of your property before any renovations.

Your CLTV ratio combines your mortgage balance plus home renovation loan relative to the appraised value of your home.

More importantly, the LTV ratio you receive will be dependent on your lender and the loan program you qualify for. 

>> More: Mortgage LTV vs. CLTV

Are Home Renovation Loans Safe?

Yes, home renovation loans are generally safe. Like traditional loans, home renovation loans also come with their share of risks. Before taking out a renovation loan to fund your home repair projects, you must consider these risks and discuss them with your lender. 

Bottom Line: Home Renovation Loans

Often, homeowners and homebuyers tend to shy away from carrying out the necessary renovations or buying a home that needs repairs. Their reasons are always not far from the fact that financing the cost of repairs comes at a substantial financial cost. Fortunately, home renovation loans offer homebuyers and homeowners the opportunity to secure the funds needed to carry out the various repairs needed in their property. 

While home renovation loans are an excellent financing option, you should consider the pros and cons before applying to get one.

Speak with your online mortgage lender to determine whether a particular home renovation loan program is best for your current home repair needs. 

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Elijah Bishop
Elijah Bishop

Elijah A. Bishop is a Senior Personal Finance Writer who has been writing about real estate and mortgages for years. He has a Bachelors of Arts Degree in Creative writing from Georgia State University and has also attended the Climer School of Real Estate. He also holds a realtor license and has been in and out of the US mortgage industry as a loan officer. Bringing over 15 years of experience, Elijah produces content that analyzes ethnicities, race, and financial well-being. His areas of expertise are mortgages, real estate, and personal loans.