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If you’re considering a home remodeling project, you’re probably thinking about borrowing money, as this work can be quite costly.

Here we will cover all the ways to pay for home renovations to help you find the smartest, cost-effective options for your particular situation.

When should you consider a home renovation loan?

Simply put, this type of loan is for people who don’t have the cash to finance the project they have in mind. This could be everything from a new roof or furnace to a kitchen or even an addition to the home.

When considering renovations, bear in mind that the total cost will probably involve much more than just labor and materials. Often, this figure includes fees for architectural and engineering services, inspections and permits, and potentially having to put up a contingency reserve of 10 percent.

Various types of loans are available, most of them contingent on how much equity you have built up in your home. Whatever your project, there’s probably a mortgage or personal loan right for you. Options include:

Home renovation loan Minimum credit score Minimum down payment/equity required
Fannie Mae HomeStyle loan 620 5% down payment
FHA 203(k) loan 620 3.5% down payment
Home equity loan / HELOC 620 20% equity
Cash-out refinancing 640 20% equity

How do you choose the best renovation loan?

“It really comes down to credit and eligibility,” says Gregg Harris, president of LenderCity Home Loans, a division of BBMC/Bridgeview Bank Group.

For example, an FHA 203(k) might be best for a borrower with so-so credit and little money to put down since borrowers can get a mortgage with only 3.5 percent down.

Consider how much you want to borrow and what it is you want to change. It can be hard to identify the best home renovation mortgage for your needs, so work with a lender who has extensive knowledge of the different loans, advises Laurie Souza, national business development manager at Mortgage Network Inc. in the Boston area.

“Make sure you’re working with a lender that is well-versed with the details of the program,” she says.

Remodel loan pitfalls to watch out for

In deciding whether to seek a loan, one financial issue is whether–and if so, how much–the renovations would increase the home’s value. Some projects may increase the value beyond their cost. But with others, you may not get back the cost of remodeling when you sell; some projects simply aren’t worth doing from a cost standpoint, although you may want to do them anyway because it improves your lifestyle. Think: Adding that in-law suite or extra bedroom.

When weighing renovations from a return standpoint, it’s a good idea to pay attention to the total amount you’d have in the home after finishing the work, 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 investing more in a home, through the purchase price and remodeling, than the values of these comparable homes, as they’ll affect your eventual sale price.

What are the costs and fees involved with a renovation loan?

That all depends on which type of financing you choose. With a cash-out refinance of your mortgage, you can expect to pay about 3 percent to 6 percent of the new loan amount for closing costs. A personal loan may have no fees but much higher interest. Closing costs for HELs and HELOCs are typically low and might include an application fee and or appraisal fee that together would be less than $500.

Of course, the major cost is interest paid on the loan, which might stretch over 20 or more years with some of these options. A $50,000 loan at 6 percent interest will cost nearly $86,000 to repay by the time the last check is written.

Here’s detailed information on financing available for renovations:

Government-backed home renovation loans

Fannie Mae’s HomeStyle Loan

  • Loan amounts can be as high as 75 percent of the home price plus renovation costs or the as-completed appraised value
  • HomeStyle funds can be used for any renovation project
  • Funds can be used to complete a real estate deal that has repair contingencies, such as replacing a roof
  • Requires you to use a certified contractor
  • Funds go into an escrow account, not directly to the borrower

One of the best-known loans for home improvements, Fannie Mae’s HomeStyle Renovation Loan, allows borrowers to either buy a place that needs repairs or refinance their existing home loan to pay for improvements.

HomeStyle loans are available from any Fannie Mae-approved lender, but there are qualification requirements:

  • For a primary residence, you must have a credit score of at least 620.
  • You have to make a down payment of at least 5 percent of the purchase price of the home.
  • A certified contractor must prepare and submit a cost estimate and details of the work to be done.

One advantage of a HomeStyle loan is that it’s just one loan, you don’t have to take out a loan for the mortgage and then another loan for home repairs. Getting just one loan reduces paperwork and closing costs.

Keep in mind that the money goes into a separate escrow account that’s used to pay contractors directly. You don’t have access to those funds as  you do with a home equity loan or a cash-out refinance.

“The nuance with the HomeStyle loan is that there’s a little less freedom for the customer because the funds are held in an escrow account,” says Eric Wilson, director of operations at Better Mortgage.

FHA 203(k) loans

  • Funds can be used for a wide range of projects, whether minor improvements (costing at least $5,000) to total reconstruction (as long as the original foundation remains)
  • Can be used to convert a building to a one- to four-unit property
  • Affordable interest rates for those with imperfect credit
  • Property must meet government energy efficiency and structural standards
  • Requires you to use a qualified 203(k) consultant
  • You can’t use an FHA loan on a property that you intend to flip within 90 days. Rules limit how soon you can resell it, and under what circumstances
  • Funds go into an escrow account, not directly to the borrower

The Federal Housing Administration offers a home renovation loan called a 203(k). There’s typically a lower credit-score requirement for this loan than there is for a HomeStyle loan, and a lower minimum down payment–3.5 percent.

There are two types of FHA 203(k) loans:

  • Limited (formerly called streamline)
  • Standard

A limited FHA 203(k) loan is designed for cosmetic improvements and is capped at $35,000. This rehab loan can be used to finance repairs and improvements like a kitchen remodeling or a new paint job.

A standard FHA 203(k) loan can be used for extensive remodeling, but it requires you to hire a qualified 203(k) consultant to oversee every step of the work, from the plans to the finished product.

This type of home renovation loan is available for homes that are at least a year old. The rehab project must have a cost of at least $5,000. The agency sets mortgage amount limits by state, county or area, and you can look your area up through a searchable tool on its website.

There’s security in having the consultant. Most people doing a major home improvement project hire a contractor on their own, notes Stuart Blend, regional sales manager for Planet Home Lending. But with a standard 203(k) loan, the consultant is your project manager, who assesses costs and plans, and oversees the work.

“When you take out that loan, that money rests with the lender. We’re holding those funds in escrow, and we’re making sure everything is done the way it’s supposed to be done,” Blend says.

Private home renovation loans

Home equity loan or line of credit (HELOC)

  • Interest rates are lower on home equity loans and HELOCs than unsecured personal loans
  • With HELOCs, you pay interest only on the amount you draw down
  • With a home equity loan, you have a predictable repayment schedule with equal monthly payments
  • May have upfront fees, including application or loan processing fees, appraisal fees, document fees and broker fees

Another way to finance your home renovation is by taking out a home equity loan, also known as a second mortgage. This is a one-time, lump-sum loan, so it’s not subject to fluctuating interest rates, and monthly payments remain the same for the loan term.

A similar loan is the home equity line of credit, or HELOC. It has a revolving balance and might be best for someone who has several large payments due over time, as with a big home-improvement project.

With either option, you’re pledging your home as collateral, meaning that if you don’t make your payments, the lender will end up owning your house. Alternatively, you can take out an unsecured personal loan to avoid putting up your home as collateral.

Keep in mind that HomeStyle and FHA 203(k) loans have some advantages over home equity loans, especially if you don’t have a ton of equity in the property.

“The loan amount with either of these is based on the completed value and not the present value. A home equity loan is based on the current value,” says Harris of BBMC/Bridgeview Bank Group.

Cash-out mortgage refinance

  • No restrictions on use of the money
  • Lower interest rates than an unsecured personal loan
  • Extends the time to payoff of your house
  • Requires significant home equity

A cash-out refi allows homeowners to refinance their mortgage. This mortgage will be for a higher amount than the first one, and the homeowner gets the difference in cash.

Like home equity loans and HELOCs, cash-out mortgages require homeowners to use their home as collateral. A refinance works especially well if you can get a lower rate than with your current mortgage. Combine the lower interest rate with the added home value derived from renovations, and you could benefit more in the long run.

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. Credit score requirements vary per loan amount and value of your home, but generally start at 640.

Personal loans

  • No collateral, home equity or down payment required
  • Flexible for any purpose
  • No home appraisal required
  • Interest rates based on consumer’s credit score and history
  • Funding available quickly

An option for those who can’t — or don’t want to — tap home equity is applying for a personal loan from a bank, credit union or online lender. Unlike a refi or home equity loan, a personal loan is unsecured — meaning you don’t have to put up your home or any other collateral. Instead, eligibility for the loan is based strictly on your credit score, income and financial history. There’s no need for a home appraisal and funds for your renovation project can be available quickly.

Naturally, consumers with excellent credit scores–720 or higher–get the best interest rates, averaging well below 10 percent APR. Those with good or average credit scores, between 630 and 719, can generally expect to pay higher interest rates. Certain lenders extend personal loans to consumers with credit scores as low as 580, though rates tend to be much higher still.

For nationwide rates, check out Bankrate’s Personal Loan Center.

If a personal loan is appropriate, you can quickly get an idea of available lenders and estimated interest rates by entering a few pieces of information into Bankrate’s loan pre-qualification tool.  If you’re eligible for quick approval, you may soon be ready to move forward with your dream of a new kitchen, bathroom or other home project

This is generally a good time to seek a loan, as interest rates are still hovering at or near historic lows and lenders are looking to hand out cash to borrowers. The key is to have a realistic idea of project costs and secure the type of loan, with a competitive interest rate, that’s right for your situation.