3 Reasons Why You Shouldn't Use a Construction Loan for Your Renovation
Because you do have better options to finance your home improvements
If you’re reading this article, someone probably told you the best way to finance your home renovation is with a construction loan. Sorry, but to put it bluntly, you’ve been given bad advice! We get it; you need a lot of money to turn all your current home into your dream home, and construction loans sound great because they allow you to borrow based on the value of your home after the renovation is complete. And while up until recently, this really was the only option, that’s not the case anymore. You have options… better ones.
Whether you talked to your bank or a friend who went through a similar process, they most likely didn’t mean to intentionally steer you in the wrong direction, but today’s market has changed in a good way! Which is why it’s really unfortunate that many people who shouldn’t be using construction loans for their renovations still are, simply because they think it’s their only option for home improvements. Before we talk about the new financing options available, let’s look at the three reasons why a construction loan is no longer the best choice of funds for most renovation projects:
1. You Must Refinance
Were you one of the lucky people to lock in an awesome mortgage rate when they were at all-time record lows? Virtual high five! After a smart move like that, you’re probably not trying to give it up, and we don’t blame you. Unfortunately, with a construction loan, you’re required to refinance your home, which means losing that great first mortgage rate you earned in the process.
Refinancing can sometimes kill two birds with one stone; you get a better rate and the money you need to do your renovation. But if you’ve recently refinanced, there’s no need to go through the process again and incur more fees. Or even worse, refinance into a higher interest rate. For example, let’s say your current rate of 3.5% becomes 5% after refinancing. Over the life of your mortgage, that 1.5% difference will most certainly cost you tens of thousands of dollars and possibly $100k+ in additional financing costs.
2. Higher Costs
What’s worse is that refinancing into a higher interest rate isn’t the only part that stings. With the refinance requirement of a construction loan, you’ll have to pay closing costs based on the new value of your mortgage + your renovation budget, as opposed to just on the renovations alone. For example, if you have a $500k mortgage and a $200k renovation budget, you’re forced to pay closing costs on a $700k loan versus a $200k loan.
In addition to closing costs, the lender’s fees are also higher for a construction loan as compared to a typical refinancing or other types of loans. That means on top of the usual loan origination and processing fees, appraisal fees, etc., you’ll be footing the bill for all the additional underwriting costs, contractor background checks, and construction inspections throughout the process — just to name a few. Again, this ends up being thousands of dollars more when all is said and done.
3. The Process Involves More Work
In reality - construction loans are a pain in the butt — for both you and your general contractor. Ever notice that when you Google “how do construction loans work?” the answers are never short and sweet? That’s because the process isn’t either.
Construction loans were originally intended for builders to turn a bare plot of land into a beautiful new home, and this created a lot more risk to a lender in terms of collateral. As a result, stringent requirements were implemented throughout the process to protect the lender. Unfortunately, whether you’re building a house from scratch or just completing a renovation on an existing home, construction loans are one-size-fits-all and not based on specific needs — meaning that you have to adhere to these same requirements. This translates to extra tasks like working with your contractor to create a draw schedule, organizing — and waiting on — inspection visits, the involvement of project supervisors, and the frequent communication with your lender requiring detailed plans and information throughout the construction process (which your contractor will hate too). If you don’t have to go through these extra steps, why would you?
So What’s the Alternative to Construction Loans?
The one alluring quality of a construction loan is the ability to borrow more money based on your home’s post-renovation value. But a construction loan is no longer the only way to borrow against your home’s increased value. Introducing: renovation home equity loans — which offer that same attractive increased borrowing feature without all the downsides discussed above. In other words, by choosing a renovation home equity loan, you can get the most money for your renovation project without the higher monthly payments, additional costs, frequent headaches, and refinancing requirement.
Every home renovation is unique, but more often than not, by using a construction loan, homeowners are choosing an option that wastes time and money simply because they don’t know what else is out there. You’re not alone in the process. If you’re looking for a better way to finance your home renovation, we can help. Contact RenoFi to discuss our renovation home equity loan and help you get started on your renovation project.