Construction Loans vs Home Equity Lines of Credit: Which Is Better for Home Improvements?

If you’re looking to renovate or build a new home you’ll likely need financing to cover the costs. Two common options for funding major home projects are construction loans and home equity lines of credit (HELOCs). But which one is the better choice?

I’ve taken an in-depth look at construction loans versus HELOCs to highlight the key differences and help you determine which is the right fit for your situation.

What Are Construction Loans and HELOCs?

First, let’s quickly define what each of these financing options entails:

Construction Loans

• Specialty loans designed for building a new home or renovating an existing property
• The loan amount is based on the estimated future value of the home after construction
• Requires closing costs like a traditional mortgage
• Interest accrues as soon as the loan is taken out

HELOCs

• Revolving line of credit secured against your home’s equity
• Loan amount is based on your current home equity, usually up to 85%
• Typically has lower closing costs than construction loans
• Only pay interest on the amount you actually use

Now that we’ve covered the basics, let’s delve into the key differences between construction loans and HELOCs when it comes to eligibility, costs, flexibility, and more.

Construction Loan vs HELOC: Key Differences

Eligibility and Qualification

To qualify for a HELOC, you’ll need to have substantial equity built up in your current home. Most lenders require a loan-to-value (LTV) ratio of 85% or less to approve a HELOC.

Construction loans, on the other hand, are based on the estimated future value of the home after renovations or construction is complete. This makes them a good option if you don’t have enough home equity for a sizable HELOC.

The lender will evaluate the building plans and specifications to determine the future home value and loan amount. Construction loans typically require a down payment of 10-30%.

Costs and Fees

Closing costs for construction loans tend to be higher than for HELOCs. Since construction loans function more like traditional mortgages, you’ll have to pay origination fees, application fees, and other closing costs.

HELOCs usually have lower upfront costs. Some lenders even cover closing costs. You may just pay appraisal and application fees.

Once the loan or line of credit is open, construction loans accrue interest from day one. HELOCs only charge interest on the amount you actually borrow.

This gives HELOCs an advantage for projects that take place over an extended timeframe. You minimize costs by only using what you need.

Loan Amount

With a HELOC, the maximum you can borrow is based on your home’s equity, typically up to 85% of the appraised value minus what you owe on your mortgage.

For construction loans, the loan amount depends on the projected budget and future appraised value of the home after renovations. Loan-to-value ratios can go up to 80-90% for construction loans.

If you don’t have sufficient equity for the HELOC amount you need, a construction loan allows you to borrow more based on the home’s expected worth.

Flexibility in Use of Funds

A major perk of HELOCs is flexibility. You can access the line of credit as needed for renovations, but also use it for other purposes if needed.

With construction loans, the lender dictates what the funds can be used for. The draws are tied to specific renovation costs and milestones outlined in the loan agreement.

Interest Rates and Repayment Terms

Construction loans typically have higher interest rates than HELOCs. They also usually have faster repayment terms of 6 months to 5 years.

HELOCs tend to have lower variable rates and longer repayment periods of 10-20 years. This further reduces overall interest costs, especially if you only borrow what you need.

If having a fixed interest rate is important to you, a home equity loan may be a good middle ground option.

When Is a Construction Loan the Best Choice?

Here are a few situations where a construction loan may be your best or only option:

• You have limited home equity and can’t qualify for a large enough HELOC
• You need to finance new home construction
• You prefer having a lump sum for your project rather than a revolving credit line
• You want the certainty of fixed payments and interest rate
• Your renovation plans are clearly defined with set costs

Construction loans make sense when you don’t have substantial equity, need more funding than a HELOC provides, or want more structure around the loan.

When Should You Opt for a HELOC Instead?

Here are some scenarios where a HELOC is likely the better financing choice:

• You have significant equity available to tap in your current residence
• Your project costs and timeline are uncertain or likely to change
• You want to complete renovations in phases over time
• You want to minimize overall interest costs
• You may need funds for other purposes beyond renovations

In general, if you have enough equity and want maximum flexibility, a HELOC is hard to beat. You only tap what you use and can access more funds in the future if needed.

Other Alternatives to Consider

Though construction loans and HELOCs are two of the most popular options, here are a couple other financing methods you could consider:

Home Equity Loan – This provides a lump sum like a construction loan, but with fixed rates and potentially lower costs than a HELOC. However, you can only use the funds for agreed-upon purposes.

Cash-Out Refinance – If you have significant home equity and low interest rates, a cash-out refinance can provide funds for renovations while consolidating your debts into a new mortgage.

Secured Personal Loan – While unsecured personal loans have higher rates, a secured personal loan uses your home equity as collateral to offer better rates. This can supplement a HELOC or construction loan if you need additional funds.

Tips for Choosing the Right Financing

• Shop around and get quotes from multiple lenders to compare rates and fees. Small differences can really add up over the life of the loan.

• Look at the total costs, not just upfront fees. Construction loans have higher ongoing interest, while HELOCs give you more flexibility to minimize costs.

• See if you pre-qualify for both financing options. This gives you a better picture of how much you could potentially borrow with each.

• Understand the tax implications. HELOC interest is usually tax deductible while construction loan interest may not be. Consult a tax pro.

• Consider a hybrid approach – a construction loan to finance the bulk of renovations paired with a small HELOC for additional flexibility.

The Bottom Line

Construction loans and HELOCs can both be great options to fund major home building and renovation projects. Construction loans are better for those with limited home equity, while HELOCs provide unmatched flexibility for borrowers who have tapped significant equity already.

Carefully compare costs, loan amounts, tax perks, and your own needs to determine if a construction loan or HELOC is the right choice for your upcoming project. With the right financing in place, you can focus on bringing your home improvement dreams to life!