Construction Loans versus Home Equity Lines of Credit

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Bryan Dornan

Founder, RefiGuide

Homeowners often want to make many improvements to their home. It is after all where they live and spend most of their time. Homeowners also want to renovate their home to add value to it before they put it on the market and a construction loan and a home equity credit line are two popular finance vehicles.

It is very critical to find banks, lenders or brokers that extend niche products that help consumers best finance construction. There are two major types of loan programs that can accomplish your home renovation dreams:

  1. Construction or home improvement loan
  2. 2nd Mortgage or home equity line of credit

What are they and what are the advantages and disadvantages of each?

Construction Loan

A home construction loan can be obtained for new construction or renovation to an existing home.  Below are the common characteristics of construction loans:

  • The loan amount is usually not equal to what the construction cost is. It is usually lower by 2-8%.
  • The construction process must be planned out on a strict schedule. You as the borrower, the lender and contractor will work on several ‘draws’, which are structured payments or installments that are released as the work is being done.
  • Your loan repayment is done over 3-5 years in most cases, and the interest rate can be fixed or variable. If you get a fixed rate, you are charged a flat interest rate from the time of the first draw.
  • The home and land are collateral for the loan.

If you are going to get a construction loan to do your renovations, many experts advise that you get a loan from a larger bank or financial institution. This will allow you to get a better interest rate. Experts also advise that you go for a fixed interest rate so that you know exactly what you will be paying and for how long.

Home Equity Line of Credit

A construction or home improvement loan is a loan that is separate from the mortgage on your property. On the other hand a home equity loan is a loan that is given against your equity in your home. Here are the major factors of this type of loan:

  • The loan is granted according to the amount of equity you have in your home.
  • You can usually borrow up to 80-90% of your home equity. For example, if you have a mortgage of $400,000 and the home is now worth $480,000, you should be able to get a home equity loan of $70,000 from many lenders.
  • A home equity loan has a fixed interest rate and the repayment is over the life of the home loan, which could be 15 or 30 years for most people.
  • This type of loan is known as a second mortgage, which means that if you fail to pay, the lender can foreclose and work with the primary lien holder. Or the lender can sell the home. Also, the lender can wait until the bankruptcy has concluded and sell the home.

The major types are the home equity loan and the home equity line of credit (HELOC). The home equity loan provides you with one lump sum of equity to fund your home improvements, while the HELOC provides you with a line of credit that you can tap as you need it for your home improvements.

Home Construction Loan

Compare the HELOC to the construction loan to finance home remodeling and rehabilitation.

Which Loan is Better

It depends upon your circumstances. Getting a construction or home improvement loan allows you to do home improvements but it is on a set schedule and the money is disbursed by the lender as certain milestones are met.

Also, the construction loan is of a limited duration, with a loan period of three to five years being most common. This will increase the amount of your monthly payments.

But on the up side, your interest rate is usually fixed and you will result in paying less interest over time given the short duration of the loan.

For doing home improvements, there is little doubt that a home equity loan or home equity line of credit is the most popular. A loan based upon your home’s equity provides you with a low interest rate, but it will be a bit higher than your first mortgage interest rate.

If you choose to get a HELOC loan, you will pay interest only payments for the first five or 10 years of the loan, and then the interest rate will jump as you start to make principle payments as well. A home equity loan has a fixed rate.

Whether you get a HELOC, an equity loan or a cash back refinance, you will pay the loan over many years, which will reduce your monthly payments. However, you will need to pay much more in interest than a construction or home improvement loan. Check the current HELOC rates from national finance companies.

Bottom Line

Most people who want to fund home improvements choose to tap their home equity with an interest only HELOC or home equity loan with a fixed rate. The facts that the interest rate is low and you can pay the loan over 10+ years means that it simply costs you less in monthly payments each month.

Of course, you are paying more interest than with a construction loan. It often comes down to how much you can afford to pay each month, and how much interest you are comfortable paying over the life of your loan.

Both of these loan products can work for your home improvement needs. You just need to determine which works better for you depending upon your current finances.

About Bryan Dornan

With over 20 years in the mortgage industry, Bryan Dornan has started several companies, such as the Lead Planet, Mortgage Lenders Plus and the Refi Guide. Mr. Dornan has written hundreds of finance related articles in an effort to promote home-ownership to consumers across the United States.