3 Reasons Why You Shouldn't Use a Construction Loan for Your Renovation

There’s a better financing option for 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 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.

Construction loans used to be the only option...until RenoFi Loans.

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!

Now, RenoFi Loans also provide renovation financing using the after renovation value that allows you to borrow more.

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 are forced to refinance and pay more.

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.

You might be refinancing into a higher rate.

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.

How much money will you lose with a higher rate?

For example, say your current rate of 3.5% becomes 5% after refinancing.

Let’s do the math:

That 1.5% difference will cost you tens of thousands of dollars and possibly $100k+ in additional financing costs.

You may be wondering - who would ever refinance into a higher rate? Surprisingly, 60% of homeowners do refinance into a higher rate, because they think that’s the only way to get the cash out that they need.

It’s not worth it!

How do I know if a RenoFi loan is right for my project?

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2. You’ll pay higher closing costs.

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.

Just how much higher?

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.

Let’s do the math:

3% in closing costs means a construction loan’s closing costs will add $15,000 in costs! That’s $15,000 that could be funding your renovation instead.

Lenders fees for construction loans are higher than any other loan type.

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. You won’t get your money right away because of the complicated draw process.

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 require:

  • Frequent property inspections
  • Small withdrawals based on project milestones
  • Lots, and lots of paperwork

Why are construction loans more complicated than other loans?

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.

Instead of getting all of your money to your contractor up front, you can only get the money in installments - giving you and your contractor a huge headache.

Take a look at a construction loan draw schedule… yeesh.

Photo Credit: Real Estate Finance HQ

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 no matter what.

Some contractors will refuse jobs because of these complications.

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?

The Reasons Why Contractors HATE Construction Loans

Let’s take a look at just why contractors hate construction loans so much…

1. They’re A Lot of Work

As much as you don’t like extra paperwork, neither does your contractor.

And with a construction loan, there’s a lot of extra steps required of your contractor throughout the process.

Here’s a breakdown of how it works: your renovation funds are held in an escrow account and typically distributed in five draws throughout the project. When the contractor makes a request for a draw, they have to go through the individual process for that specific bank, which chances are—they’ve never done before. Then the bank has to order an inspection from a third party, which can take anywhere from a few days to over a week. After the inspection, the contractor and the homeowner will have to sign approvals for the additional draw. (Some lenders may even require a mechanic lien waiver, requiring additional paperwork and signatures.)

Once the bank reviews the request, the release of approved funds will again require final signatures from you and your contractor. Often, e-signatures won’t cut it, which means yet another task of delivery. This process is repeated for each draw throughout the project — we’re tired just thinking about it.

2. They Slow Down the Project

You can imagine how a process like this can really delay your project. For just one loan, your contractor must make a request and wait for inspection five different times. So let’s say it takes a week for an inspector to come out each draw—that could add an extra 5 weeks on to your completion date.

3. You Don’t Get All of Your Money

What’s more… despite all the extra work, the bank may not even give your contractor the full draw. Some lenders will withhold 10% of each request—known as a holdback—until the end of construction when a final inspection is performed to ensure everything was completed as expected. And let’s just say whenever your contractor has to pay out of pocket to keep a project moving, they aren’t thrilled about it.

RenoFi Loans: The better construction loan alternative.

The one alluring quality of a construction loan is the ability to borrow more money based on your home’s after 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 — home renovation loans which offer that same attractive increased borrowing feature without all the downsides discussed above.

RenoFi Loans have:

  • No requirement to refinance
  • No higher closing costs
  • No complicated draw process

Check out this side-by-side comparison - you’ll see that RenoFi Renovation Home Equity Loans (on the left), beat out all of the other construction loan options.

Renovation Home Equity LoanSingle-Close Construction To Permanent Loan (CTP)Fannie Mae HomeStyle LoanFHA 203k (Full)Two-Close Construction To Permanent Loan (CTP)
Is this a mortgage?YesYesYesYesYes
1st or 2nd mortgage?2nd1st1st1st1st
Require refinance of existing mortgage?NoYesYesYesYes
Typical Interest RateMarketAbove MarketAbove MarketAbove MarketAbove Market
Loan Limit (Renovation Cost + Mortgage)$500,000Jumbos allowedConforming onlyConforming onlyJumbos allowed
Loan Term (max)20 years30 years30 years30 years30 years
Credit Score Required660+700+620+580+580+
Loan to ValueUp to 95%Up to 95%Up to 95%Up to 96.5%Up to 80%
Can be used for building new home?NoYesNoNoYes
Restrictions on type of improvements?NoNoNoYesNo

In other words, by choosing a RenoFi Loan, you can get the most money for your renovation project without the higher monthly payments, additional costs, frequent headaches, and a refinancing requirement.

The main things you need to know about RenoFi Loans are:

  • You can borrow between $25k and $500k
  • Fixed rates as low as 4% (varies by state and lender)
  • Terms of up to 20 years
  • Ability to borrow up to 90% of your home’s after renovation value
  • The full loan amount is available at closing
  • You won’t need to refinance your existing mortgage

Sounds too good to be true? See how much you can borrow with the RenoFi Loan Calculator now.

What if My Contractor Refuses to Work with a Construction Loan?

Many contractors hate construction loans. And since these loans will typically cost your contractor more time and money, it’s hard to blame them. But when your contractor actually refuses to work with a construction loan completely, then what do you do?

Basically, you have two options.

1. Choose a Different Loan

You do have other options; options contractors actually love—like RenoFi Loans. That’s because they are way less of a pain than construction loans.

Here’s what we mean:

The assumption most contractors make about construction loans that exist today (FHA 203K, Fannie Mae Homestyle, etc.) is that it will require a lot more time and money—which is probably true. That’s because every time your contractor needs more money, they have to make a request with the bank, wait for an inspection, and sign a bunch of paperwork before the funds are released. On top of that, there’s significant money held back by the bank with this process too.

With many of these renovation loans, your bank will hold back some of the funds with each release—or draw—until the end of the project as a means to protect themselves. This “holdback” is 10% of the draw amount, so with up to 5 draws per loan, this really adds up. As a result, your contractor may have to pay out of pocket to finish the job.

With a renovation home equity loan—like a RenoFi Loan—you’re in control of the distribution of the funds and there’s no time-consuming inspections or paperwork to hold your project up. You can start your search for a new loan right here, and when you do find the right financing for you, make sure to communicate your payment schedule with your contractor so you’re on the same page.

2. Find a New Contractor

We always encourage homeowners to get more than one estimate, so you’re never in a position where your contractor dictates how you finance your renovation.

But if you don’t already have a backup, and you’re set on your construction loan, the other option is to start the vetting process again. In this case, it may be helpful to talk to the bank you are using for your construction loan, and see if they have any recommendations based on who they’ve worked with in the past.

Even with a recommendation, you want to consider contractors that have done a lot of work in your local area of similar size and scope to your project. Friends, family, and neighbors can also be good resources, while third party sites or local Facebook groups can be a good place to see what other people are saying about their recent projects.

FAQs on Construction Loans

Construction loans let homeowners borrow money based on the value of the property after the proposed construction is complete. These loans require an as-completed appraisal and a lengthy process where homeowners draw loan money in installments based on construction inspections by a third party. They’re loans for the purpose of building a home from the ground-up, that some people also use for major renovations as well. They have a progressive drawdown, meaning that you (or your contractor) receive the loan amount in installments. They’re short-term loans that convert to a permanent mortgage. These loans require refinancing, and have higher interest rates & fees than traditional mortgages.
Yes. In many cases you can, however they were designed to be used for new construction. For some smaller projects a construction loan isn't necessary, but some homeowners do use them for major renovations.
  • The loan process is complex.
  • Homeowners will receive the funds in installments called “draws” only after periodic inspections of the construction progress, slowing down the project for general contractors. The installment schedule is determined by a hired inspector.
  • This is one of the most expensive financing options - closing costs are higher than typical mortgages and you pay fees for the inspections.
  • You’ll need to refinance your first mortgage, and many people don’t want to refinance into a higher rate.
  • The high minimum credit score makes the option unattainable for some homeowners.
RenoFi Loans are an alternative to construction loans as they offer the same increased borrowing power based on the after renovation value, but homeowners get the entire loan amount up front making it easier on the homeowner and the contractor.
If you already own the home they do not require a down payment, though typically you can only borrow up to 80% of the future home value.
Construction loans typically require a minimum credit score of above 700, and a DTI ratio below 43%, among several other factors.
Some contractors refuse to work with construction loans because of the lengthy draw and inspection process they require.

 

For more information on alternative loan options or how to find the right contractor for you, contact RenoFi to discuss your renovation project.

How do I know if a RenoFi loan is right for my project?

The RenoFi team is standing by to help you better understand how RenoFi Loans work and the projects they are best suited for. Have a question - Chat, Email, Call now...