3 reasons why you shouldn't use a construction loan for your renovation

If you’re reading this article, someone probably told you the best way to finance your home renovation is with a construction loan. Sorry, but to put it bluntly, you’ve been given bad advice!

We get it; you need a lot of money to turn your current home into your dream home, and construction loans sound great because they allow you to borrow based on the value of your home after the renovation is complete.

Construction loans used to be the only option...until RenoFi Loans.

Whether you talked to your bank or a friend who went through a similar process, they most likely didn’t mean to intentionally steer you in the wrong direction, but today’s market has changed in a good way!

Now, RenoFi Loans also provide renovation financing using the after renovation value that allows you to borrow more.

Which is why it’s really unfortunate that many people who shouldn’t be using construction loans for their renovations still are, simply because they think it’s their only option for home improvements.

To help you to make the right decision as to the best way to finance home improvements, we’ll talk you through exactly how construction loans work, giving you the information that you need to make the right decisions about financing your renovation.

What Is a Construction Loan?

• They’re loans for the purpose of building a home from the ground-up, that some people also use for major renovations as well.
• They have a progressive drawdown, meaning that you (or your contractor) receive the loan amount in installments.
• They’re short-term loans that convert to a permanent mortgage.
• These loans require refinancing, meaning you’ll need to sacrifice any existing rates you’ve locked in.
• They often have higher interest rates & fees than traditional mortgages.

How Do Construction Loans Work?

Construction loans were never originally intended to be used as a way to finance renovations, rather as a way to turn a plot of land into a new home. Something that, as you’d expect, carries a lot of risk.

For this reason, a complex set of stringent requirements are put in place to protect the lender. These same requirements must be adhered to by anyone who takes out a construction loan, regardless of whether that’s to finance a remodel or a new home construction.

They’re a one-size-fits-all loan and don’t take into account the specific circumstances surrounding the project.

This means that there’s a lot more work involved by all parties than with other types of home renovation loans.In fact, some of these requirements are actually why many contractors hate construction loans for renovations.

The one alluring quality of a construction loan is the ability to borrow more money based on your home’s after renovation value. But a construction loan is no longer the only way to borrow against your home’s increased value.

Why Construction Loans Aren’t the Best Option for Renovations

Before we talk about the new financing options available, let’s look at the three reasons why a construction loan is no longer the best choice of funds for most renovation projects:

1. You are forced to refinance and pay more.

Were you one of the lucky people to lock in an awesome mortgage rate when they were at all-time record lows? Virtual high five! After a smart move like that, you’re probably not trying to give it up, and we don’t blame you.

Unfortunately, with a construction loan, you’re required to refinance your home, which means losing that great first mortgage rate you earned in the process.

You might be refinancing into a higher rate.

Refinancing can sometimes kill two birds with one stone; you get a better rate and the money you need to do your renovation. But if you’ve recently refinanced, there’s no need to go through the process again and incur more fees. Or even worse, refinance into a higher interest rate.

How much money will you lose with a higher rate?

For example, say your current rate of 3.5% becomes 5% after refinancing.

Let’s do the math:

That 1.5% difference will cost you tens of thousands of dollars and possibly $100k+ in additional financing costs.

You may be wondering - who would ever refinance into a higher rate? Surprisingly, 60% of homeowners do refinance into a higher rate, because they think that’s the only way to get the cash out that they need.

It’s not worth it!

2. You’ll pay higher closing costs.

Refinancing into a higher interest rate isn’t the only part that stings. With the refinance requirement of a construction loan, you’ll have to pay closing costs based on the new value of your mortgage + your renovation budget, as opposed to just on the renovations alone.

Just how much higher?

For example, if you have a $500k mortgage and a $200k renovation budget, you’re forced to pay closing costs on a $700k loan versus a $200k loan.

Let’s do the math:

3% in closing costs means a construction loan’s closing costs will add $15,000 in costs! That’s $15,000 that could be funding your renovation instead.

Lender fees for construction loans are higher than any other loan type.

In addition to closing costs, the lender’s fees are also higher for a construction loan as compared to a typical refinancing or other types of loans.

That means on top of the usual loan origination and processing fees, appraisal fees, etc., you’ll be footing the bill for all the additional underwriting costs, contractor background checks, and construction inspections throughout the process — just to name a few.

Again, this ends up being thousands of dollars more when all is said and done.

3. You won’t get your money right away because of the complicated draw process.

In reality - construction loans are a pain in the butt — for both you and your general contractor. Ever notice that when you Google “how do construction loans work?” the answers are never short and sweet? That’s because the process isn’t either.

Construction loans require:

• Frequent property inspections
• Small withdrawals based on project milestones
• Lots, and lots of paperwork

Why are construction loans more complicated than other loans?

Construction loans were originally intended for builders to turn a bare plot of land into a beautiful new home, and this created a lot more risk to a lender in terms of collateral.

As a result, stringent requirements were implemented throughout the process to protect the lender.

Instead of getting all of your money to your contractor up front, you can only get the money in installments - giving you and your contractor a huge headache.

Take a look at a construction loan draw schedule… yeesh.

Unfortunately, whether you’re building a house from scratch or just completing a renovation on an existing home, construction loans are one-size-fits-all and not based on specific needs — meaning that you have to adhere to these same requirements no matter what.

The Reasons Why Contractors HATE Construction Loans

Let’s take a look at just why contractors hate construction loans so much…

1. They’re A Lot of Work

As much as you don’t like extra paperwork, neither does your contractor.

And with a construction loan, there’s a lot of extra steps required of your contractor throughout the process.

Here’s a breakdown of how it works: your renovation funds are held in an escrow account and typically distributed in five draws throughout the project. When the contractor makes a request for a draw, they have to go through the individual process for that specific bank, which chances are—they’ve never done before. Then the bank has to order an inspection from a third party, which can take anywhere from a few days to over a week. After the inspection, the contractor and the homeowner will have to sign approvals for the additional draw. (Some lenders may even require a mechanic lien waiver, requiring additional paperwork and signatures.)

Once the bank reviews the request, the release of approved funds will again require final signatures from you and your contractor. Often, e-signatures won’t cut it, which means yet another task of delivery. This process is repeated for each draw throughout the project — we’re tired just thinking about it.

2. They Slow Down the Project

You can imagine how a process like this can really delay your project. For just one loan, your contractor must make a request and wait for inspection five different times. So let’s say it takes a week for an inspector to come out each draw—that could add an extra 5 weeks on to your completion date.

3. You Don’t Get All of Your Money

What’s more… despite all the extra work, the bank may not even give your contractor the full draw. Some lenders will withhold 10% of each request—known as a holdback—until the end of construction when a final inspection is performed to ensure everything was completed as expected. And let’s just say whenever your contractor has to pay out of pocket to keep a project moving, they aren’t thrilled about it.

RenoFi Loans: The better construction loan alternative.

The one alluring quality of a construction loan is the ability to borrow more money based on your home’s after renovation value. But a construction loan is no longer the only way to borrow against your home’s increased value.

Introducing: renovation loans — home renovation loans which offer that same attractive increased borrowing feature without all the downsides discussed above. RenoFi offers three different products through our lending partners:

• RenoFi Home Equity Loan
• RenoFi HELOC
• RenoFi Cash-out Refinance

All of which use the after renovation value of your home to determine how much you can borrow.

RenoFi Loans have:

• No requirement to refinance
• No higher closing costs
• No complicated draw process

Check out this side-by-side comparison - you’ll see that RenoFi Renovation Home Equity Loans (on the left), beat out all of the other construction loan options.

In other words, by choosing any one of the three RenoFi Loan options, you can get the most money for your renovation project without the higher monthly payments, additional costs, frequent headaches, and a refinancing requirement.

See how much you can borrow with the RenoFi Loan Calculator now.

FAQs on Construction Loans

For more information on alternative loan options or how to find the right contractor for you, contact RenoFi to discuss your renovation project.