Whether you’re looking to renovate your kitchen, install a home office or finish your basement, any major home improvement is going to require some major money. You don’t have to wait until you have all the cash in hand, though. A home renovation loan could be your path to getting the project underway sooner than you think.

What is a home renovation loan?

A home renovation loan is a loan that includes funds for renovating, remodeling and repairing a home. It’s often a mortgage with extra money for home improvements. It can be in the form of:

• A purchase mortgage, with additional funds for renovations
• A refinance of your current mortgage with a cash payout for home improvements
• A home equity loan or line of credit (HELOC)
• An unsecured personal loan
• A government loan, such as Fannie Mae HomeStyle loan or FHA 203(k) loan

You don’t necessarily have to live in the home already; some home renovation loans can be used to buy a fixer-upper and make upgrades right away without the need to apply for separate financing.

Most home renovation loans require the borrower to have a certain amount of equity in the home, though personal loans usually do not.

When should you consider a home renovation loan?

If you don’t have enough cash to finance renovations or repairs, a home renovation loan is worth considering. It’s also worth pursuing if you have your eye on a home that has a low asking price but needs serious work.

These loans can be a big boost for homeowners or buyers who want more control over building equity in their property by making improvements — but they’re generally only underwritten for substantial upgrades, not handyman work. If a project will improve the value of the property, a home renovation loan can be a valuable tool.

“I would only recommend taking out a renovation loan if the costs of the renovation are still well below the current value of the home,” says Gregg Harris, president of LenderCity Home Loans in Chesterfield, Missouri. “It is also important that they will positively impact the value of the home over the long run. So, things like bathrooms, kitchens and additions make the most sense.”

Home renovation loan options

Fannie Mae HomeStyle Renovation loan

The Fannie Mae HomeStyle Renovation loan allows borrowers to either buy a place that needs repairs, or refinance their existing home loan and get money for improvements.

One advantage of a HomeStyle loan is that it’s just one loan with one monthly payment; you don’t have to take out a loan for the mortgage and another loan for home repairs. Getting one loan cuts down on time and closing costs.

The loan money goes into a separate escrow account that’s used to pay contractors. Borrowers do not have access to those funds as they would with a home equity loan or cash-out refinance. In addition:

• Renovation costs are limited to 75 percent of the “after-repaired value” of the home.
• There are stricter credit score and debt-to-income ratio standards to qualify.
• It usually takes longer to close than a conventional mortgage loan.

FHA 203(k) loan

Credit score and down payment requirements are less stringent with a Federal Housing Administration 203(k) loan, also known as a 203(k) rehabilitation or rehab loan. There are two types of FHA 203(k) loans:

• Limited 203(k) loans are capped at $35,000.
• Standard 203(k) loans are for major rehabilitation or construction.

A standard FHA 203(k) loan requires a qualified 203(k) consultant to oversee every step of the work, from the plans to the finished product.

This home renovation loan is available for homes that are at least a year old, and the renovation project must cost at least $5,000. The FHA also sets mortgage amount limits by location.

Other features of an FHA 203(k) loan include:

• Affordable interest rates for those with imperfect credit, but lender fees may be higher.
• Rehab funds are placed in escrow and released as the work progresses.
• Funds cannot be used for a property that will be sold within 90 days.

Home equity loan or HELOC

A home equity loan is a fixed-rate, lump-sum loan with monthly payments that remain the same for the loan term. A home equity line of credit, or HELOC, has a credit limit and revolving balance. This loan works for homeowners who have several large payments due over time on a big home improvement project.

With either option, you’re pledging your home as collateral, meaning that if you don’t make your payments, you could end up losing your house.

There are other key considerations with home equity loans and HELOCs, as well:

• Interest rates on home equity loans and HELOCs are lower than they are on unsecured personal loans.
• With HELOCs, you pay interest only on the amount you withdraw.
• Equity loans may have upfront fees, such as application or loan-processing fees.

Cash-out refinance

A cash-out refinance allows homeowners to refinance their mortgage for a higher amount than the previous mortgage, based on how much equity they have, and take out the difference in cash.

Like home equity loans and HELOCs, cash-out refis require homeowners to use their home as collateral. A refinance works well if you can get a lower rate than what you’re paying on your current mortgage. A lower interest rate and an increase in home value as a result of renovations are great long-term benefits.

You’ll need at least 20 percent equity in your home to qualify for cash-out refinancing. The total loan amount is generally limited to the available equity in your home. In addition:

• There are no restrictions on use of the money.
• The loan is based on current home value, not post-improvement value.

Personal loan

An option for those who can’t or don’t want to tap home equity is a personal loan from a bank, credit union or online lender. Unlike a refi or home equity loan, a personal loan is unsecured, so you don’t have to use your home or any other asset as collateral. Loan eligibility is based on your credit score, income and financial history.

Naturally, consumers with “very good” FICO credit scores of 740 and up get the best interest rates on personal loans, which can be below 6 percent APR. Some lenders extend personal loans to consumers with credit scores as low as 580, though the rates on those tend to be much higher. You can quickly find lenders and interest rate ranges through Bankrate.

If you’re eligible, you could be ready to move forward with your new kitchen, bathroom or other home project. Overall, the benefits of a personal loan include:

• Flexibility; loan can be used for most any purpose
• No home appraisal required
• Funding can be available quickly

Costs and fees for home renovation loans

The costs and fees of a home renovation loan depend on the type of loan you get. With a cash-out refinance, you can expect to pay about 3 percent to 5 percent of the new loan amount in closing costs, which include charges such as the lender’s origination fee and the cost of a credit report check and an appraisal.

“Closing costs are higher on renovation loans, perhaps as much as 1 percent of the loan amount higher,” says Michael Becker, loan originator and sales manager at the Baltimore retail branch of Sierra Pacific Mortgage. “Rates are also higher.”

A personal loan may have no fees but a much higher interest rate. Closing costs for home equity loans and lines of credit (HELOCs) are typically lower, but might include an application and appraisal fee.

The major cost, of course, is the interest paid on the home renovation loan, which can stretch over 20 or more years with some loans. A $50,000 renovation loan at 6 percent interest, payable over 20 years, will cost nearly $36,000 in interest by the time the last check is written.

Home renovation loan projects

Some home renovation loans can be used for nearly any improvement project you have in mind, while others have restrictions about how the money can be used.

For example, the FHA 203(k) loan has a long list of eligible improvements, such as replacing a roof, flooring and plumbing, removing safety and health hazards and upgrading to accommodate a person living with a disability. However, the loan can’t be used for a luxury improvement, such as building a backyard swimming pool or hot tub, and the loan is only for primary homes, not second homes or vacation residences.

On the other hand, the Fannie Mae HomeStyle loan can be used to improve a vacation home or investment property, and any renovation or repair is eligible for funding, as long as it’s permanently affixed to the property and adds value to it.

If you borrow against your home equity to renovate your home, you can do pretty much any project you want, but you should consider whether the project will add to your home value. For example, new garage doors and a remodeled kitchen are considered high-impact upgrades that can help you recoup more of your investment when you sell.

A cash-out refinance can have the double benefit of letting you refinance a higher-rate mortgage to one with a lower rate while pulling out cash to spruce up your property.

Personal loans also give the borrower lots of leeway regarding the type of improvements that can be made. Lenders also have a lot of leeway regarding the amount of interest they can charge you, though. Simply put, if you’re borrowing money at a 25 percent interest rate, you’re going to pay far more than might be necessary to complete your project.

How to choose a home renovation loan

As you consider options for a renovation loan or a remodeling loan, here’s a rundown of how to get the best deal for your finances and the best fit for your needs.

1. Review your credit

Before applying for any loan, it’s important to remember that your credit plays a critical role in locking in the lowest interest rate. If you have time, consider taking steps to improve your score by paying down credit card bills and making all payments on time. If your credit isn’t great and you have little money to put down, an FHA 203(k) loan might be best, since you can get a mortgage with only 3.5 percent down.

2. Estimate the cost of your project

What will your labor costs be? What about supplies? Will you need to rent a place to live elsewhere while the project is happening? Put together a comprehensive budget. The size of that number can help you understand which loan will be best, and you can also estimate your monthly payments.

3. Know how much equity you currently have

If you’re looking to renovate your existing home, take a look at your monthly mortgage statement to understand how much equity you have accrued.

“If a borrower has the ability to pull the money out of their home to pay for renovations via a cash-out refinance or a home equity loan or line of credit, the costs of obtaining money for the rehab or renovation would be less,” Becker says. “The problem with doing that is when you don’t have the equity in your home to pull out that cash.

“If doing the rehab will add value to your home and you don’t have much equity in your home as-is, then a 203(k) loan or Fannie Mae HomeStyle Renovation loan may be your only option,” Becker says.

4. Comparison shop

Just as you did with your mortgage — and just as you should do anytime you make any big financial decision — look at payment terms and fees from a few different lenders. Rates and costs vary from bank to bank, so do your research (and your math) to make sure you get the best deal. The only thing better than renovating your home is renovating it while knowing you’re getting a good deal on borrowing the money.

Home renovation loan pitfalls to watch for

While renovating your home may sound exciting, remember that these projects — and borrowing the money to make them a reality — can come with significant drawbacks. Don’t let your upgrade come with any of these downsides:

Making an investment that isn’t worth the cost

Are you planning on selling this home eventually? If so, it’s important to note that buyers might not be willing to pay more for the upgrade you made.

“The biggest risk is over-improving a home,” Harris says, cautioning against spending so much that it exceeds the best possible value of the home over the long term.

When considering a home renovation loan, find out whether the renovations would increase the home’s value, and if so, by how much. Pay attention to the total amount you would have put into the home after the work is done, relative to an appraiser’s estimate of the total after-project value.

You also want to consider the values of comparable homes in the neighborhood that have sold recently. A major pitfall lies in spending more to purchase and remodel the home than what comparable homes in your neighborhood are worth, as this will affect your eventual sale price.

Failing to account for extra costs

Cost overruns are another pitfall to avoid. When considering renovations, keep in mind that the total cost will probably involve more than just labor and materials. The total often includes fees for architectural and engineering services, inspections and permits, and potentially having to put up a contingency reserve of 10 percent.

Being unrealistic about the timeline

Renovating a home is not a simple task. Consider the potential implications of delays in the project. If supplies arrive late or your contractor encounters an unexpected issue, your project can stretch on for weeks longer than you anticipated. If you’re renovating your kitchen, that means more meals out. If you’re renovating a bedroom, it could mean more time in a rental while you wait to move back in.

Next steps

It’s a good time to apply for a home renovation loan because interest rates are low. Before you apply, check your credit score so that you know what kind of borrower lenders will see you as. Also, it’s important to have a realistic idea of project costs and get the right type of loan, with the best rate you can qualify for and a payment that fits your budget.