Imagine finding a home for sale in your dream neighborhood. The house is picturesque from the sidewalk, but then you get closer. There’s some peeling paint and a few broken fence posts. Nothing a bit of elbow grease can’t fix, right? Then you step inside. The carpet is worn. The walls are scuffed and the plaster is cracking. The water heater is due to be replaced. The list goes on. During the tour, one thing becomes very clear: This home needs a renovation. That’s why there are home improvement loans!

While most people expect to do a little work to make the home they buy their own, few things are more disappointing than walking into your dream home and discovering it’s in need of thousands of dollars in repairs.

The reality is many homebuyers don’t have piles of cash set aside to deal with home renovations after they close on a house. Funding those repairs with credit cards or personal loans are options but both of those will cost you thousands of dollars in interest over the long run.

That’s where home renovation loans can save the day. Never heard of them? A lot of people haven’t, but they’re a great way to complete renovations without using credit cards or other more expensive options. Home renovation loans are a type of loan that lets you borrow against the future value of your home after proposed renovations are completed rather than the value at the time of sale.

Whether you’ve heard of home renovation loans or not, you probably have questions about them. This guide answers some of the most common questions about this type of loan.

What kinds of home renovation loans are there?

There a few different types of home renovation loans. They typically fall into two categories: government loans and conventional loans. Government loans are insured by government agencies while conventional loans are typically backed by private lenders, such as a bank or mortgage brokerages. The following are examples of home renovation loans:

Federal Housing Administration 203(k) loan: The Federal Housing Administration offers a home renovation loan officially called 203(k) Rehab Mortgage Insurance. This government loan enables homebuyers and homeowners to finance both the purchase (or refinancing) of a house and the cost of its rehabilitation through a single mortgage or to finance the rehabilitation of their existing home.

There is a full version of this loan and a limited version. The limited 203(k) loan has a renovation limit of $35,000. The full version does not have a set upper limit (it’s based on the county in which you’re purchasing) but does have a minimum of $5,000 in renovation costs.

The full 203(k) allows any type of renovation except the inclusion of luxury items. The limited 203(k) allows any type of renovation except the installation of luxury structural work, additions, and landscaping.

Veterans Affairs Administration loan: At one time, the Veterans Affairs Administration also offered a home renovation loan. The loan could be used to purchase or refinance a home. It required a 0% down payment and had a maximum of $35,000 in renovation costs for minor, non-structural repairs or renovations. Know more about VA Loans in: Your Complete Guide to the VA Loans

As of this guide’s publishing date, that government loan product has been placed on hold. It’ll hopefully come back in the near future, but you can click here to learn more about the loan program.

Fannie Mae HomeStyle® loan:

Fannie Mae offers two types of HomeStyle® Renovation Loan types for homebuyers.

HomeStyle® can be used to purchase or refinance a home. It requires a down payment of 5% if the home will be owner-occupied or 10% if it’s a second home. This type of loan permits all renovation work, including the installation of luxury items.

HomeStyle® 3% Down features a lower down payment than its peer at 3%, but it can only be used for renovations on a home purchase, not refinancing. This type of loan permits all renovation work, including luxury items, but the renovations must add value to the property.

Both HomeStyle® loans have less stringent standards for borrowers than private lenders like banks. That means things like your credit score don’t need to be as strong for this type of government loan.

Renovation home equity loan:

Known as Home Equity Line of Credit (HELOC), this type of home renovation loan allows you to use the equity in your home as collateral. Equity is the difference between your home’s value and your mortgage balance. You can tap into it to pull funds for a renovation. Think of it as a credit card. It’s a revolving source of funds you choose when you use.

With these loans, there’s a draw period when you’re given access to the funds. Draw periods typically last 10 years and you’ll be limited on the amount times you can withdraw money. Usually, you’ll get four interim draws and a final draw. Each of those draw requests will have a 10% holdback to be paid out with the final draw. After that draw period closes, borrowers usually receive a 20-year repayment period. HELOCs are conventional loans that don’t put restrictions on the type of renovations you can do. Options and fees for these loans vary significantly among lenders.

You can view a comparison chart of these loan options here.

How do I get home improvement loans?

Like any process, getting a home improvement loan might seem complicated. However, if you break it down step by step, things get a little clearer.

Step 1: Get pre-approved

The first step on your journey to a home renovation loan is getting pre-approved to purchase a home. You would take this step with any other type of mortgage you are pursuing. What does pre-approval mean? It involves visiting a lender and filling out a mortgage application. The lender will review your application and will examine your financial interests to determine the mortgage amount you qualify for and how likely you are to pay back your mortgage. Note: The amount you’re approved for has to include the total of the housing price plus the renovation costs. For example, if your max budget is only $150,000, then the total purchase price and renovations cannot exceed $150K.

When the lender examines your finances, it means looking at your bank accounts, your debt, your employment history, and other relevant information. They also conduct a credit check. If all goes well, you’ll receive an official letter from your lender with the amount you are approved for borrowing. Mortgage pre-approval letters are typically valid for 60 to 90 days. The reason for the expiration date is that your finances and credit profile could change in that timeframe.

It’s worth noting that being pre-approved for a mortgage is not the same as being prequalified. Prequalification is a similar process to pre-approval but is less formal and doesn’t involve a credit check. Pre-approval is more valuable than prequalification because it shows you’ve been vetted as a borrower.

Step 2: Assemble the right team

You need a home buying and renovation team with knowledge and experience that will make the process go smoothly.

First, you’ll want to find a loan officer and real estate agent with experience in purchases that involve home renovation loans. If you aren’t already working with a real estate agent, ask your loan officer for a recommendation. It’s likely they’ve worked with many in your area and may be able to suggest someone who has worked on renovation deals before.

Next up is a contractor. You can speak with your loan officer about a recommendation for this job, too. There’s a good chance they’ve worked with experienced contractors and can match you with the right person for your needs. If you decide to find your own contractor, make sure they’re licensed in the state that you’re purchasing for and have the required insurance.

 Pro tip: Finding the right contractor is key to moving forward with home renovations. They will be required to fill out quite a bit of paperwork for this process, so it’s best to find one general contractor instead of trying to bring on multiple contractors.

It’s worth looking around for the right professionals in this case because inexperience could result in some bumps along the way. Those issues could prolong the process or even bring it to a halt. When you have a team of people that are experienced in home renovation loans, you’re already off to a great start!

Step 3: Find a home to buy

For most, searching for your ideal house is the fun part of the process. Here is where you get to imagine your vision of the perfect home. Visit possible options and think about what your custom-tailored dream kitchen or bathroom will look like.

What other updates would you like? Is there other remodeling needed, such as a new roof or windows? Remember, a renovation loan doesn’t have to be done on a foreclosed property or a home that looks like it is about to fall over. It can be done on a perfectly good home that just needs a makeover.

If you find a home that you love, then it’s time to make an offer with a longer closing date than a normal real estate transaction. On average, a normal closing would take about 50 to 55 days. It’s recommended to close in 90 days for home renovation loans.

Step 4: Finalize your sales agreement and contractor bid

Once you’ve found a house that you want to purchase and your offer is accepted, it’s also time to bring in your contractor. They’ll need to walk through the house with you before you write up an offer and give you a rough estimate of what the cost of the renovations that you need will be.

Keep in mind that you may need upgrade items to the home that aren’t necessarily pretty to look at but are necessary to the function, structure, or safety of your home, such as installing new electrical wiring. However, depending on your budget, you can get all the items completed on both your needs list and wants list. Your contractor will need to provide you with a written bid or estimate outlining all the work that will be done.

One thing to note is that renovation loans do have a unique process for contractors to follow when submitting bids. Make sure your contractor is aware of what lender you are working with and that they are OK with the process.

Step 5: Start the loan application process

Once you have your accepted sales agreement to purchase the home and your final bid or estimate from your contractor, you can start your loan application with your loan officer.  The loan officer will need both the sales agreement and the bid before the loan application can be started.

Also as part of this step, it’s important to order an appraisal of the home. The appraisal cannot be ordered without the bid from your contractor because the appraisal process is a little differently compared to a typical mortgage. Normally, an appraiser just needs the purchase price of the home. For a home improvement loan, both the purchase price and the home’s estimated value upon completing a renovation need to be included. The appraiser needs to know what upgrades you’re making to the home, and they estimate what the value will be with everything completed.

Step 6: Time to close

After your loan is approved and all necessary paperwork is provided, it’s time to finalize the process at the closing. During this meeting, you will sign all your final paperwork and get the keys to your new home. The seller will get their money for the home sale and the rest of the money is put in a separate account with your lender. This money will be disbursed to the contractor as laid out in the estimate. A portion of the funds is released at the closing for your contractor to begin the work and, depending on how large of a renovation you are doing, the money will be released in phases after certain projects are done and signed off on by a certified inspector. Your lender will control all the funds for the renovation work and communicate directly with you and your contractor.

Finally, you can begin your renovation (literally, immediately after closing). Once it’s finished, sit back, relax, and enjoy your new space—the dream home that you imagined and made a reality.

That’s it. Just six straightforward simple steps. All your fears and doubts about considering a renovation loan should be washed away. But, if they’re not and you still want to renovate, the right loan officer can walk you through the process and make it as stress-free as possible.

Are home improvement loans more “expensive” than other borrowing options?

Some homebuyers do get hung up on the fact the interest rate for home renovation loans tends to be a bit higher than a traditional mortgage. That said, it’s not a huge difference. Typically, they’re only about a quarter of a percent higher.

There’s also an underwriting fee that does get added you’re doing these types of loans, but it’s very minimal in comparison to what the loan allows you to do. If you compare this slightly higher cost spread out over 30 years and compare that to using credit cards or personal loans, these mortgages will save you a ton of money in the long run.

There are other costs involved with home improvement loans. Your home will be inspected three times for appraisal as renovation work progresses. Each appraisal will likely cost around $200.

As part of the process, you’ll also need to establish a contingency reserve. Your lender will require that between 10 and 20% of your project budget needs to be set aside into an account and accessed only for over-budget costs.

If you are doing $30,000 in renovations, that would be $3,000 to $6,000 that would be put into an account in case the renovation costs run over. If you don’t use your contingency reserve for renovation projects, it will be applied to your loan balance at the end of the whole process.

Pro tip: Don’t get hung up on where the best interest rate is at. Home renovation loans will save you a ton of money in deferred maintenance. And they’ll help you sell your home for more down the road. If your interest rate is slightly higher than a loan without renovations, this type of loan might still be a better option as it spreads out the renovations over 30 years at a great interest rate.

Do I qualify for a home improvement loan?

Many people may wonder how hard it is to be approved for a home renovation loan. The good news is that it’s just as easy to get approved for a renovation loan as it is for any other type of loan. There’s just more homework involved that you and your homebuying team need to be more diligent about. Be sure to get accurate and complete documents to your lender, contractor, loan officer, or real estate agent in a timely manner to keep your loan process moving.

Each home renovation loan mentioned in this guide has its own set of standards for financial health indicators, such as your credit score.

The FHA 203(k) loan is going to be best for homebuyers whose credit scores fall below 680 or you don’t have a large sum saved up for a down payment. The 203(k) has a down payment requirement of 3.5%.

If your credit score is above 680, and you do have some money that you are willing to put into the house, then a HomeStyle® Renovation Loan is a great option. This loan allows first-time home buyers a 3% down payment.

Both of the above loans are good options for purchasing and renovating single-family homes. If you’re looking to purchase a home with two to four units, then the FHA loan is one of the best options for keeping more cash in your pocket.

What about other types of homes? If you’re looking to buy and renovate a condo, it possible to use both of the above loans. One thing to note is FHA loans require the condo to meet a set of standards to be considered “approved.” It’s not recommended to pursue an FHA loan with an unapproved condo. Manufactured (mobile) homes are prohibited from using the FHA and HomeStyle® loan products.

As for HELOCs, the qualifications for borrowing against your home’s equity vary by lender, but it common that your equity will need to be at least 15% to 20% of your home’s value (this is determined by an appraisal). You’ll also likely need a credit score of 620 or higher and a strong history of paying your bills on time. Finally, lenders would like to see a maximum debt-to-income ratio of 43%—possibly up to 50%. Your debt-to-income ratio is the percentage of your gross monthly income spent on monthly debt payments such as rent, credit cards, and student loans.

What is a HUD consultant?

If you’re pursuing a 203(k) loan and your total renovation costs exceed $35,000 or if you have renovation work that involves the home’s foundation, you’ll have to get what’s called a HUD consultant or 203(k) consultant. Most 203K consultants are licensed home inspectors, general contractors, and sometimes architects. They are tasked with inspecting the home and renovation work to ensure it meets HUD housing standards. They will cost anywhere between $350 to $1,000 to employ. The cost is scaled based on the total renovation cost.

How long does it take to close a home improvement loan?

On average, it takes about 50 days to close on a home, from the signed contract to the closing.

The renovation loan process does take longer to complete at about 90 days. If you are working with a lender that has experience with renovation loans, your process might be a little faster.

Still have questions about home improvement loans? The professionals at Keystone Alliance Mortgage can help you get answers!