How to Get a Construction Loan for Home Renovations

If you’re looking to renovate or add on to your existing house a construction loan can provide the financing you need to complete your project. Construction loans allow you to borrow money in stages to pay for materials and labor as the work progresses. They can be a great option for major home renovations when a regular mortgage or home equity loan isn’t enough.

In this article we’ll explain everything you need to know about getting a construction loan for renovations, including

• What construction loans are and how they work
• Types of construction loans for home improvements
• Costs and fees associated with construction loans
• Requirements to qualify for a renovation loan
• The process of applying and getting approved
• Pros and cons to weigh before borrowing
• Tips for choosing the best construction lender

What Is a Construction Loan?

A construction loan is a short-term loan used to finance building a new home or renovations on an existing property. With a home renovation loan, funds are disbursed in stages as the work is completed rather than all at once like a standard mortgage.

Construction loans are issued for 6 to 12 months on average. The repayment period is shorter because the lender wants to minimize risk until the renovations are finished and the home reappraised to confirm the value has increased as expected.

Since the loan isn’t yet secured by the finished improvements, lenders have stricter eligibility requirements for borrowers. But construction loans allow you to finance much larger projects than you could likely cash-flow or qualify for with a home equity loan or line of credit.

Loan Types for Home Renovations

There are a few varieties of construction loans to know about if you’re planning major renovations:

Single-close construction-to-permanent loan – This combines the construction loan and permanent mortgage into one loan. Once the renovations are complete, the loan automatically converts to a fixed-rate mortgage with monthly principal and interest payments amortized over 15 or 30 years. This avoids having to requalify and close on a second loan.

Two-close construction-only loan – With this type, the construction loan has a term of 6 to 18 months. When the project is done, the loan must be paid off with cash or refinanced into a traditional mortgage. The benefit is you lock in a low rate for the rebuild project alone.

FHA 203(k) rehab loan – This FHA-insured mortgage covers purchase plus renovations, or refinancing plus renovations on an existing home you already own. It’s a good lower credit score option and you can finance up to $35,000 in renovations.

VA and USDA renovation loans – Like the FHA 203(k), these government-backed mortgages allow you to buy and remodel a home or refinance/renovate a home you own if you’re a qualified borrower.

Pros and cons of each loan type:

• Single-close construction-to-permanent loans avoid costs/hassles of a second loan but have higher rates.

• Two-close construction loans have lower rates but require second application.

• FHA 203(k) allows lower credit borrowers; max renovation amount is $35,000.

• VA/USDA loans help eligible borrowers but have stricter guidelines.

Costs and Fees

Construction loans come with costs and fees similar to other mortgages, including:

• Interest – The interest rate is usually 1 to 2% higher than rates for traditional mortgages. Expect to pay 6% to 8% with today’s rates.

• Origination fee – Upfront fee equal to 1% to 2% of the loan amount.

• Closing costs – Appraisal, application, inspection and attorney fees apply; around 2% to 5% of loan amount.

• Inspection fees – Lender may charge for periodic inspections to approve draw payments.

• Upfront interest payments – Interest accrues during construction period; you’ll likely owe interest payments upfront.

Total costs often range between $5,000 to $15,000 or more, depending on project size and loan terms. Be sure to account for these fees in your renovation budget.

Requirements to Qualify

To get approved for a home renovation loan, you’ll need:

• Credit score of at least 620, but 680+ rates are better. 720+ for the best rates.

• Debt-to-income ratio below 45% including new loan payment.

• Down payment of 10% to 20% may be required.

• Home equity of 15% to 20% is often needed if renovating an existing home.

• Cash reserves equal to 6+ months mortgage payments may be required.

• Appraisal confirming home value will increase enough to support loan request.

• Contractor bids and project plans must be approved by the lender.

Meeting these requirements demonstrates you can afford the loan and project costs. Stricter criteria reduce lenders’ risk on unsecured construction loans.

The Loan Application Process

Applying for a construction loan involves extra steps compared to a regular mortgage or refinance. Here are the key stages:

1. Submit renovation plans – Provide detailed project plans, contractor bids, and a cost breakdown.

2. Show home value will increase – An appraisal must confirm improvements will boost property value proportional to loan amount.

3. Prove you can repay the loan – Verify income, assets, credit score, and cash reserves meet requirements.

4. Have contractor approved – Lender reviews credentials and licensure of general contractor.

5. Close on the loan – Initial loan documents are signed and down payment deposited.

6. Make draw requests – As work is completed in stages, funds are requested and released after inspection.

7. Pay interest – Monthly or upfront interest payments are required on borrowed amounts.

8. Complete renovations – Final inspection verifies project is finished per approved plans.

9. Pay off/convert loan – Construction loan is due or converts to permanent financing after 6-12 months.

Following these steps, it can take 45-60+ days to close on a construction loan if you have all your ducks in a row. Rushed or incomplete applications can greatly delay the process.

Pros and Cons of Construction Loans

Construction loans provide flexible financing for major home renovations, but also come with some downsides to consider:

Pros

• Renovate and expand beyond what regular loans allow
• Only pay interest on disbursed amounts during construction
• Tap home equity without selling or refinancing
• Convert to permanent mortgage without second closing

Cons

• Higher rates and fees than traditional loans
• Stricter lender eligibility requirements
• Loan amount fixed upfront; change orders can get costly
• Short repayment term; project delays can be problematic
• Two closings if loan doesn’t convert to mortgage

Construction loans make big projects feasible by spreading out the financing as work progresses. But the borrowing costs and risks involved mean they aren’t the right solution for small renovations.

Tips for Finding the Best Construction Loan Lender

Choosing the right lender is key to getting a construction loan that best fits your home and budget. Here are tips for finding the optimal lender:

• Shop around – Compare loan costs, terms, and requirements from multiple lenders. Online lenders often have the lowest rates.

• Ask about convertibility – See if the loan can convert to a permanent mortgage to avoid a second loan.

• Look for draw fee waivers – Some lenders waive inspection fees to release construction draws.

• Review payment options – See if interest-only payments are allowed during the construction phase.

• Ask about change order allowances – Find out if they allow for budget overruns and how.

• Compare contractor requirements – See if they restrict who you can use or require their own inspectors.

Finding the right loan often takes some research. But taking the time can pay off with a better renovating experience and less financial stress.

The Bottom Line

While it takes more work to get approved, a construction loan can be just what you need to finance major renovations, additions, or upgrades to your existing home. Just be sure to assess your budget, home equity, and contractor before diving in. With proper planning and a loan suited to your project, you can create your dream home without the headaches.