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When interest rates are low, borrowing against your home equity to pay for renovation work is an attractive option. But more homeowners are investigating another option: the construction loan.
Which makes more sense? A lot depends on the needs of the homeowner. In most cases, a home equity loan offers more flexibility.
In general, a home equity loan allows a homeowner to borrow from the value a home has accrued. Let's say you purchased a home five years ago for $175,000, put down $50,000 on the house and obtained a mortgage for $125,000. Now, because of rising real estate values, that homes is worth $200,000. Through your mortgage payments, you've paid $5,000 toward the principal of the loan.
That means you owe $120,000 on a home that's worth $200,000. Which gives you $80,000 in equity.
On a cash-out refinance, you could get $40,000 of your home equity. On a home equity loan, you could get out as much as $64,000.
If there's any cash left after you pay off your home improvement bills, you can use the remaining money any way you please - pay off a few bills, take a vacation or send a child to college. And because it works like a mortgage, the interest on a home equity loan is tax-deductible.µ |
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 In general, a construction loan is usually a short-term interim loan geared to pay for renovation work. The length of a construction loan is usually one year. Some are available for six or nine month terms.
The loan is based on the cost of the renovation work. However, if the renovation work costs more than the house is worth, you probably won't qualify for a construction loan. Once the work is finished, the construction loan is often rolled into a bigger mortgage. Or, the interest-only payment is then converted into an interest-and-principal payment.
Construction loan money usually goes straight to the contractor or sub-contractor after certain aspects of the work are completed. These payments are called "draws". As money from the loan is disbursed at different phases, interest is kept to a minimum. As work is completed, the lender will also often inspect the home to make sure the money is being used exactly for what is was borrowed. Once the construction is 100 percent complete and according to plans, there is a final inspection of the work.
Often, the interest rate on a construction loan is higher than the rate found on a home equity loan or standard mortgage. Because they are short-term loans, however, the higher interest rate should not be so damaging.
There's another downside to a construction loan: You have to find a contractor who will agree to be paid after a segment of the job is completed. That means the contractor has to put his money up front to pay for materials and labor.
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