When it comes to financing a home addition or renovation project, two of the most common options are a home equity line of credit (HELOC) and a construction loan. Each comes with its own pros and cons, and both are widely used.
While it’s helpful to understand the basics of these two loans, we encourage you to talk with different banks and compare multiple financing options before deciding what’s best for you. Let’s walk through the key differences between a construction loan and a HELOC. By exploring your options, you’ll be one step closer to accomplishing your renovation goals!
What Is a Home Equity Line of Credit (HELOC)?
At Action Builders, we’ve been working on projects that involved banks for years. We are very comfortable with renovation or construction loans. Before COVID and the real estate explosion, we were seeing a lot of construction loans in the Pittsburgh market. Now that interest rates are higher, home equity lines of credit have increased in popularity.
The traditional home equity line of credit—or HELOC, as they are often referred to—are lines of credit lent to homeowners based on their existing house’s value minus what they own of the house with a mortgage. A HELOC is a percent of the loan to value (LTV) of the house, and most banks will lend approximately 80% LTV.
A HELOC is relatively simple to get and can be acquired through most banks. During construction, the owners have control of the funds and pay Action Builders directly at the contract’s completion points.
A very basic example is that if your house is worth $200,000 and you owe $100,000 on the mortgage, a HELOC will lend about 80% of the difference of what you owe vs. what the house is worth. You would be able to apply for a HELOC for approximately $80,000, but the loan will depend heavily on the bank and the specific loan package you end up receiving.
HELOC Pros
- You have flexible access to funds so you can get exactly what you need when you need it.
- The interest rates are competitive because this is a secured loan.
- Monthly payment amounts fluctuate because interest rates are usually variable.
- You’ll enjoy low payments since the repayment terms are usually pretty long.
- These loans provide a lot of flexibility, making them ideal for smaller projects, renovations with a flexible budget, or a series of incremental projects.
- The flexibility to draw money as needed makes a HELOC ideal if you don’t know exactly how much your renovation will cost.
- You’ll only pay interest on the amount you’ve withdrawn from the HELOC, which will keep your costs down if you’re only using part of your available funds.
HELOC Cons
- Your overall cost may be higher because the repayment period is so long.
- The amount you’re able to borrow is limited by the amount of home equity you have.
- If you default on this type of loan, it could put your home at risk.
What Is a Construction Loan?
A construction loan is a little different. This loan lends on the completed value of a home. These can be extremely useful for addition projects since we are often adding bedrooms, bathrooms, and larger kitchens to a house—which increases the overall value.
A construction loan has two appraised values: one “as is” and one with the addition or renovation complete. The bank will then lend on the higher amount (normally the proposed option). If your house is worth $200k “as is,” you owe $100k on the mortgage, and the proposed value is $300k with the addition, the bank would lend around 80% of the $200k difference between the completed value and what is owed on the existing mortgage. With a construction loan, you’re looking at approximately $160,000 compared to $80,000 with a HELOC.
The bank also keeps control of the funds during construction and releases the payments to Action Builders at the contract’s completion points. They also typically hold a percentage of the final payment until final occupancy has been achieved.
Construction Loan Pros
- Your loan amount is based on your proposed project and your home’s future value, not your available equity.
- There are shorter repayment terms, so you’ll enjoy lower long-term interest costs.
- This is a good loan option for homeowners who have not built up a significant amount of equity in their home or who want to complete projects that will cost more than the amount of equity they’re able to tap.
Construction Loan Cons
- Your loan amount is set in advance, so you’ll have minimal flexibility if any unexpected cost overages pop up.
- This loan has a higher interest rate than a secured loan.
Choosing the Best Way to Finance Your Home Addition or Renovation
Which financing option you choose depends on your needs, whether that’s a HELOC or a construction loan. The good news is that you can mix and match different financing options too! You may take out a construction loan to cover the bulk of your addition or remodel, then use a HELOC to cover unexpected costs and incidentals.
Know Your Options and Budget Carefully
Financing your addition or renovation doesn’t have to be a major stressor. Simply connect with several banks, compare their products, and choose the best fit for your long-term needs.
Take the Next Step Toward Your Beautiful Home Addition or Renovation
At Action Builders, we have been in business since 1991, and we have a good long-term relationship with several local banks. To simplify the financing of your renovation or home addition project, we connect you with our vetted local financial institutions.
Ready to make your home addition or renovation dreams a reality? Take the first step today by contacting us to schedule a consultation. Deciding on the financing option that is right for you will depend on the value of your home and what you owe on your mortgage. Reach out to our friendly team with questions and to obtain a list of bank contacts we have worked with locally.
