Have you been dreaming of a marble-top kitchen island? Or, a four seasons porch with a hot tub? Whatever your vision is to spruce up your home, you’ll need a way to fund the renovations.
In this article, we’ll cover two popular loan products for funding home renovations in the hotly anticipated debate of a HELOC vs a construction loan.
Before we can compare these two loan products, we need to cover what they are and how they work.
What’s a HELOC?
A home equity line of credit (HELOC) allows borrowers to tap into the equity in their home so they can access money through a revolving funding source. Typically, you’ll be able to borrow around 80-90% of your equity.
While you can use the funds from this loan product for anything you want, using a HELOC for renovations is pretty common. So, whether you need finances for a kitchen remodel, a basement repair, or a new dual shower system, using this revolving credit line is a popular choice.
How it works
When thinking about a HELOC vs a construction loan, it’s important to consider how they both work. This way, you can see if the process fits your preferences and situation.
With HELOCs, you’ll likely be given a maximum amount of funds to borrow, which is dependent upon the amount of equity you have in your home. It’s up to your discretion whether you want to borrow all of the funds at once or withdraw it in incremental amounts.
Similar to a credit card, a HELOC will have a variable interest rate, and you’ll only be charged interest on the amount of money you borrow during the specified month.
The typical timeline for a HELOC varies based on how much a borrower withdraws and who their lender is. But, in general, HELOCs have a 10-year draw period and a 20-year repayment period.
What’s a construction loan?
Construction loans provide the funds necessary to build a home from the ground up or to finance a major renovation. If you’re wondering, “Can I use home equity for a construction loan?” The answer is no. But, in most cases, a person who takes out a construction loan won’t have equity to access anyway since these loans are mainly used to build brand-new homes. Thus, a construction loan is “secured” by the future value of the home once the building is completed.
Construction loan versus home equity loan
Because these two loan products sometimes get mixed up, we’ll clarify the difference here. The main point of contrast between a construction loan and a home equity loan is that a construction loan is granted for the literal construction of a new house or a major home renovation; while a home equity loan is granted against the collateral of the amount of equity the borrower currently has in their home.
How it works
Alright, back to our debate of HELOC vs construction loan. Let’s talk about how construction loans work.
These loans use a process known as a progressive drawdown. This process doesn’t disburse funds to the borrower in a lump sum, and the borrower can’t take out whatever amount of money they want at any given time like they can with a HELOC. Rather, with a construction loan, the contractor who’s hired by the borrower to complete the project will receive installment payments during the building process.
Since this type of loan is usually intended to cover the costs of the construction process, it’s commonly granted for a duration of 12 to 18 months.
When debating between a HELOC vs a construction loan, it’s important to know that there are different types of construction loans.
With this type of loan, you’ll borrow money to finance the building of your home, and then convert the loan to a permanent mortgage when the construction is complete.
If you take out a construction-only loan, you’ll get the funds necessary to finish the construction, and you’ll be responsible for paying back the borrowed amount in full via cash or through a second mortgage.
Renovation construction loan
A renovation construction loan is a kind of home improvement loan that’s intended for major renovations. This type of loan can be paid back as a separate loan or converted into a mortgage once the building is finished.
HELOC vs construction loan: comparing the pros
You can’t make a smart decision about which loan product to take out when you don’t know the unique benefits each one brings to the table. So, let’s dive into the advantages.
A HELOC for home improvements gives a tremendous amount of leeway for ongoing renovations. This flexibility to use as little or as much of your funding limit at any given time allows for unforeseen budget issues that may arise during the construction process. You’ll also only pay interest on the amount of money you’ve taken out, which in turn, will keep your costs low if you’re merely using a portion of your available credit.
While the progressive drawdown structure can seem limiting, it may actually help you in the long run. How? Because its guidelines can keep you on track and prevent you from going over budget.
Likewise, having the loan amount based on the future value of the home is a great perk because it enables you to fund the project of your dreams even when you don’t have equity to tap into.
HELOC vs construction loan: comparing the cons
As you’ve read, both of these loan products offer key benefits to borrowers. But what about their drawbacks? A successful debate isn’t complete without calling out the disadvantages. So, let’s take a look at their cons.
Just like a home equity loan for a remodel, a HELOC has the potential to put your home in jeopardy. This is because the very nature of borrowing against your home puts you at risk of foreclosure if you can’t make your payments.
The other primary disadvantage of a HELOC stems from the lack of discipline a borrower may have when withdrawing funds. With easy access to fast cash, a borrower may take out money impulsively without thinking about possible financial consequences, like not being able to pay it back.
Because this type of loan doesn’t have an existing home to put up as collateral, it comes with higher interest rates, and the loan amount is set in advance. Additionally, the bank gets to decide how the loan amount is used, which cuts down on flexibility for the borrower.
When a HELOC is the best way to go
So, you’ve considered the pros and cons of a HELOC vs a construction loan. What now? Well, you need to assess your current situation to understand which option fits your scenario better.
Because HELOCs provide ample flexibility, they’re great for borrowers who want a flexible budget and have a series of small renovations with no strict time frame.
When a construction loan is the smarter choice
Conversely, taking out a construction loan is wise for borrowers who don’t have any equity to tap into or who need funds that’ll cost more than the amount of equity they do have.
Is there a middle ground?
Now, let’s say you don’t want a construction loan, but you also don’t have enough equity to qualify for a HELOC… is there a happy medium?
It turns out there is! The goldilocks between these two is a future value home equity loan. Like a HELOC, this type of loan is used to make repairs or renovations to an existing home. And, similar to a construction loan, it’s “secured” by the value of your home after the renovations are complete. So, you might say that this type of loan is juuussttt right.
HELOC vs construction loan: the bottom line
As we wrap up our HELOC vs construction loan debate, the most important thing to think about if you're considering these loan products is what’s going to be best for your situation.
At Northport, we’ll listen to your needs and preferences to help you navigate the mortgage process. Contact one of our mortgage ninjas today to answer any questions you have.