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

April 26, 2023 Mike construction loan, How do construction loans work, Loans from RenoFi

For your home improvements, there is a better financing option.

If you’re reading this, someone presumably informed you that a construction loan is the best payment method for your home remodeling. I’m sorry, but the advice you were given was wrong.

We comprehend that you require a sizable sum of money to transform your current home into your dream home, and construction loans appeal to you because they enable you to borrow money depending on the valuation of your home following the makeover.

Before recently, construction loans were the sole choice.

Loans from RenoFi.

Whether you spoke with your bank or a friend who had gone through a similar process, they certainly didn’t intend to lead you astray purposefully, but the market has altered positively today!

RenoFi Loans is now using the after-renovation value to provide renovation financing, enabling you to borrow more.

Sadly, many homeowners who shouldn’t be using construction loans for renovations do so because they mistakenly believe it to be their only option.

We’ll go through the specifics of how construction loans operate so you can decide how to finance home improvements in the best way possible. With this knowledge, you can decide how to finance your renovation.

How do construction loans work?

They are loans to start from scratch while building a home, though some people also utilize them for significant improvements.

They have a progressive drawdown, so the loan amount is paid to you (or your contractor) in installments.

They are temporary loans that become long-term mortgages.

It would help if you gave up any current rates you’ve locked in because these loans require refinancing.

They frequently have greater fees & interest rates than conventional mortgages.

How Do Loans for Construction Work?

Construction loans were never meant to be used to pay for renovations; they were meant to be used to build a new house on a piece of land. Something that, as you might think, is very risky.

A sophisticated system of onerous rules is put in place to safeguard the lender. Anyone who takes out a construction loan, whether to finance a remodel or a new home development, must follow the same rules.

They don’t consider the project’s unique conditions because it is a universal loan.

It implies that, compared to other home improvement loans, a lot more work is required from all sides. Many contractors detest construction loans for renovations because of some of these criteria.

The one attractive feature of a construction loan is the possibility of taking out extra money based on the worth of your house following renovations. However, you are no longer limited to using a construction loan to borrow against the increasing value of your house.

The Reasons Why Construction Loans Aren’t the Best Choice for Renovations

Let’s examine the three reasons why a construction loan is no longer the best source of funding for the majority of remodeling projects before discussing the various financing choices available:

1. You must refinance and pay extra money.

Were you one of the fortunate individuals to lock in a fantastic mortgage rate when they hit a historic low? Almost a high five! You probably aren’t attempting to give it up after such a wise decision, and we don’t blame you.

Unfortunately, you have to refinance your property if you use a construction loan, which means you’ll lose the excellent first mortgage rate you secured.

You may be refinancing at a higher rate.

You can occasionally receive a better rate and the funds you need for your remodel by refinancing, known as “killing two birds with one stone.” However, there is no need to repeat the process and pay additional costs if you have just refinanced. A higher interest rate refinance option is much worse.

How much cash will you lose if the rate is higher?

Say, for illustration, that after refinancing, your current rate of 3.5% becomes 5%.

Do the math: That 1.5% difference will cost you tens of thousands of dollars and perhaps even $100,000 or more in extra finance charges.

It isn’t worthwhile!

2. Your closing costs will increase.

It isn’t only the refinancing into a higher interest rate that hurts. Due to the refinancing requirement of a construction loan, you will be required to pay closing costs depending on the new value of your mortgage plus your renovation expenditure, not simply on the renovations alone.

How much higher is it?

For instance, you would be required to pay closing costs on a $700,000 loan instead of a $200,001 loan if you had a $500,001 mortgage and a $200,001 repair budget.

Let’s do the math: at 3%, closing expenses for a construction loan will increase costs by $15,000! That’s $15,000 that might be used to pay for your renovation.

Construction loans have the highest lender fees of any loan type.

In addition to closing charges, the lender’s fees for a construction loan are more than for a regular refinance or other loans.

You will therefore be responsible for paying for all additional underwriting fees, contractor background checks, and construction inspections throughout the process, for naming a few, in addition to the standard loan origination and processing fees, appraisal fees, etc.

Again, the real cost adds up to hundreds of dollars more.

3. Due to the complicated draw procedure, you won’t get your money soon.

Construction loans are, in fact, a pain in the but for you and your general contractor. answers are never condensed and straightforward? It is so that the procedure isn’t either.

Why are construction loans trickier to obtain than other types of loans?

#Construction loans were first designed to help contractors transform a vacant piece of land into a gorgeous new house, which came with a lot greater collateral risk for lenders.

As a result, strict guidelines were put in place throughout the procedure to safeguard the lender.

You can only pay your contractor in installments rather than all at once, which will cause you and your contractor great stress.

Take a look at the draw schedule for a building loan. Yeesh.

Unfortunately, construction loans are one-size-fits-all and not based on unique needs. It will help if you abode by these rules, regardless of whether you’re building a house from scratch or simply finishing a restoration on an existing property.

The Motives Behind Contractors’ Abhorrence of Construction Loans

Let’s look at why construction loan providers despise them so much.

1. They Take a Lot of Work: Your contractor doesn’t appreciate filling out more paperwork, just like you don’t.

Additionally, there are several different processes that your contractor must do throughout the process when using a construction loan.

Here is an explanation of how it functions: Your remodeling funds are placed in an escrow account, typically dispersed throughout five withdrawals. The contractor must go through the unique protocol for that particular bank when requesting a draw, which, most likely, is something they have never done before. The next step is for the bank to request an inspection by a third party, which might take a few days to over a week. After the inspection, the contractor and the homeowner must sign an authorization for the additional draw. (Some lenders would even insist on a mechanic lien waiver, which would involve more paperwork and signatures.)

The release of funds that have been approved will need final signatures from both you and your contractor after the bank has reviewed the request. E-signatures frequently fall short, necessitating yet another delivery chore. Every draw in the project goes through this same process, and just thinking about it makes us exhausted.

2. They Make the Project Slower

You can see how this procedure could seriously slow down your project. Your contractor has to submit five requests and wait for inspections for a single loan. If an inspector needs a week to arrive at each draw, your completion date could be extended by 5 weeks.

3. You Don’t Get Your Entire Investment

Furthermore, the bank could not even grant your contractor the full draw despite all the additional work. As a holdback, some lenders would defer 10% of each request until after construction is finished and everything has been inspected to ensure everything was done as agreed. And your contractor isn’t happy whenever they have to make a personal payment to keep a project on track.

RenoFi Loans: A Superior Construction Loan Substitute

We now have renovation loans, providing the same alluring enhanced borrowing feature without drawbacks. Through our loan partners, RenoFi provides three different products:

Home equity loan from RenoFi

HELOC RenoFi

Cash-out via RenoFi Refinance

All of which base your borrowing capacity on the home’s value following renovations.