Construction Loans vs Renovation Loans: Which One is Right For Your Project?

If you’re looking to build a new home from the ground up or renovate an existing property, you’ll likely need to take out a specialized type of loan to finance the project. Two common options are construction loans and renovation loans. But what exactly is the difference between these two types of lending products?

In this comprehensive guide, we’ll explain everything you need to know about construction loans vs renovation loans, including:

• What are construction loans and renovation loans?
• Key differences between construction and renovation loans
• Pros and cons of each type of loan
• Steps to getting approved
• Tips for choosing the right loan for your project

Whether you’re building new or renovating old, understanding the nuances of these two loan products will ensure you pick the financing option that best fits your needs

What is a Construction Loan?

A construction loan is a short-term financing product designed specifically to fund the building of a new home. The funds can be used to purchase land, pay for materials, cover labor costs, and take care of other expenses that come up during the construction process.

Here are some key features of construction loans

• Designed for building a new home from scratch
• Short-term loan, usually around 6-12 months
• Loan disbursed in multiple draws as construction progresses
• Interest-only payments during construction period
• Variable interest rate that fluctuates with market rates
• Must be converted to permanent financing once home is finished

Construction loans allow borrowers to only pay interest on the funds that have been drawn during each stage of the build. This helps keep payments affordable during the building phase.

Once construction is complete, the construction loan must be paid off or refinanced into a traditional mortgage or other long-term loan. This is known as permanent financing.

What is a Renovation Loan?

A renovation loan provides financing for remodeling, renovating, or repairing an existing home. Renovation loans can be used for projects ranging from minor upgrades to major overhauls.

Here are some key features of renovation loans:

• For improving existing homes, not new construction
• Can be medium or long-term loans
• Funds usually dispersed in one lump sum
• Fixed interest rate and monthly principal & interest payments
• Loan stays in place after renovation completed
• May require home appraisal

With a renovation loan, you receive the full loan amount upfront to pay for your renovation costs, rather than receiving it piecemeal as construction progresses.

Renovation loans don’t require refinancing or a conversion to permanent financing once the renovations are complete. The loan terms and interest rate remain the same from start to finish.

Key Differences Between Construction Loans and Renovation Loans

Now that you understand the basics of construction loans and renovation loans, let’s look at some of the key differences between these two products:

• Purpose – Construction loans are for building new homes; renovation loans are for upgrading existing homes
• Loan term – Construction loans are short-term, usually 6-12 months; renovation loans can be medium or long-term loans
• Draws vs lump sum – Construction loans are disbursed in multiple draws; renovation loans provide the full amount upfront
• Interest rate – Construction loans have a variable rate; renovation loans typically have a fixed rate
• Permanent financing – Construction loans require conversion to permanent financing; renovation loans do not
• Collateral requirements – Renovation loans may require a home appraisal; construction loans typically just need land value

Looking at these major differences, you can see that construction loans function more like a line of credit secured by the property, while renovation loans act more like a standard mortgage.

Pros and Cons of Construction Loans

Pros

• Only pay interest on what you draw
• Interest-only payments keep costs low during build
• Can customize features and finishes
• May increase home value with custom design

Cons

• Require refinancing into permanent loan
• Variable rates can increase over time
• Building timelines can be unpredictable
• Need technical expertise to manage process

The phased draw structure helps keep construction loan payments affordable during the building process. But you’ll need to secure separate permanent financing once the home is move-in ready.Variable rates could also rise over the short loan term leading to higher costs.

Pros and Cons of Renovation Loans

Pros

• No need to refinance after renovations
• Fixed interest rate for predictable payments
• Can tap equity without cash-out refinance
• May improve home value with upgrades

Cons

• Higher monthly payments with principal & interest
• Need home appraisal to verify value
• Preapproval not guaranteed for desired amount
• Limitations on how funds can be used

You don’t have to worry about refinancing into another product once your renovations are done. But you’ll have standard principal and interest payments right away, which are typically higher than interest-only construction loan payments.

Steps to Getting Approved

The loan application and approval process has some differences between construction loans and renovation loans.

For construction loans:

• Find a lot or land to build on
• Get prequalified with a lender
• Submit construction plans for review
• Verify development permits and builder requirements
• Have land appraised to confirm value
• Provide cost breakdowns and construction timeline
• Be approved for loan and initial draw

For renovation loans:

• Determine desired renovations and get quotes
• Check you have enough home equity for loan amount
• Gather renovation details for lender
• Go through preapproval process
• Get home appraised to confirm value
• Provide contractor estimates and scope of work
• Have renovation plans approved by lender
• Be approved for lump sum loan amount

The process has a few extra steps for construction loans related to the land purchase, builder qualifications, and drawing loan funds in phases. Renovation loans focus more on details of the renovation itself and verifying enough home equity exists to secure the loan.

Tips for Choosing the Right Loan

If you’re still unsure whether a construction loan or renovation loan is the best fit, ask yourself these key questions:

• Are you building new or improving existing? Construction = new; renovation = existing
• What is your project timeline? Construction typically 6-12 months; renovation depends on scope
• How will the home be used once complete? Primary home, investment property, vacation home?
• Can you handle variable rate fluctuations? Construction loans have adjustable rates
• Is predictability or cost savings more important? Fixed renovation rates = predictable; construction draws = potential savings

Really examine your specific project, budget, and timeline to determine if the features of a construction loan or renovation loan fit best. And don’t be afraid to work with a qualified loan officer who can guide you.

The Bottom Line

When embarking on your new build or renovation project, make sure you fully understand the differences between construction loans and renovation loans. Construction loans help fund building a new home with flexible draws and variable rates. Renovation loans provide upfront lump sums at a fixed rate to finance existing home improvements.

Consider the pros and cons for your specific plans and finances to decide which option offers the features that best align with your needs. With the right loan choice, you’ll be set up for success on your building or remodeling endeavors.