A home-renovation loan can help you turn a fixer-upper into your dream house, but not without risks

home for sale sign price reducedJustin Sullivan / Getty ImagesWhat is a home-renovation loan? It's an alternative to a home-equity loan or HELOC.Justin Sullivan / Getty Images

  • I never expected to fall in love with a fixer-upper, but it happened. And in order to turn that farmhouse into my dream home, I had to find out everything I could about home-renovation loans.
  • Home-renovation loans can be wrapped into your mortgage loan and cover the cost of repairs on a property, such as upgrades to heating and cooling and even a new bathroom or kitchen.
  • Home-renovation loans can help you build equity fast, since you're more in control of the value of your home, but only if you know what you're doing.
  • Visit Business Insider's homepage for more stories.

I was not expecting to walk into a 1920s farmhouse with broken windows, lead paint, and a bird's nest in the attic and say, "I love it."

Yet last month, while on an open-house tour of an up-and-coming historical Baltimore neighborhood, I did just that. But before I can even think about buying the property, I'll need to learn about getting a home-renovation loan.

What is a home-renovation loan?

A home-renovation loan is a type of loan, often wrapped into a mortgage loan, that includes the costs of renovating a "fixer-upper."

You might consider getting one if you're interested in buying a home at a lower price point and taking on the costs of fixing it up. Buyers choose to do this for a number of reasons, including personal pleasure or as a way to gain equity faster than they normally would when buying a move-in ready house, since you're more in control of establishing the value of your house.

Home-renovation loans may cover costs such as installing or updating heating and cooling systems, energy improvements, roofing, waterproofing, mold remediation, etc., in addition to desired renovations like a new kitchen or bathroom that could add value to the house.

In many cases, an appraisal for a home-renovation loan will include up to 110% of the home's after-improved value. This is particularly helpful if the home is in need of deferred maintenance, such as a hot water heater with one to two years of life left in it.

You can build your dream home, but there's some risk involved

For one thing, home-renovation loans can be a bit more costly than standard home loans. Buyers sometimes combat this by buying down the permanent rate, which means paying for interest up front to reduce their future monthly payments. Another way of combating the price of a reno loan is to refinance after six months.

Douglas Boneparth, a certified financial planner at Bone Fide Wealth, says that the potential to earn equity through a home-renovation loan is doable - but not without thoughtful preparation. He advises first-time homebuyers to be very wary of the promise of "fast equity" and make sure they understand all the costs involved before moving forward with a fixer-upper.

"The likelihood that a new homebuyer will successfully maximize equity on their first try using a home-renovation loan is rather low," says Boneparth, explaining that getting good at building wealth through real estate takes experience.

How much home can you afford? Use this calculator to find out:

What you need to know to get a home-renovation loan

1. Consider your timeline.

Heidi Gage, branch manager at Movement Mortgage in Baltimore, Maryland, says that, in her experience, renovation loans close in an average of 35-45 days, which is on par with the timing for a standard purchase transaction in her market. Check with your loan officer to learn the average closing time for home-reno loans in your area.

2. Understand the difference between FHA, conventional, and VA loans.

FHA loans are best for buyers with lower credit scores, and they often require private mortgage insurance because buyers typically need only put 3-4% down. 

Conventional renovation loans can be used in conjunction with conventional mortgages for both appraiser-required and borrower-selected upgrades.

A VA loan is used by qualified veterans to pay for renovations above the appraised cost of the home.

In addition to these three common home-renovation loans, there are a number of other options that vary depending on your location and circumstances.

Not all lenders are federally or state-qualified to offer home-renovation loans, so if you know this is what your heart desires, the best thing to do is develop a relationship with a loan officer and ask every single question you have until you find the right fit for you.

Each loan qualification is based on your mortgage credit score, your employment history, your existing debts, and local regulations.

3. Be realistic with your budget.

It might be tempting to underestimate repairs to try and save money on your monthly payment, but you must keep the big picture in mind. Nothing is worse, says Gage, than having to return to your loan officer a year later to refinance another renovation loan because you were too optimistic the first time around.

Boneparth advises clients who are interested in a home-renovation loan to mitigate the risks of unexpected repair costs by attending homebuyer workshops, understanding all costs, and having a solid sense of their budget.

"When the closing process is all said and done, you've made all your desired renovations, and you've unpacked all of your belongings," asks Boneparth, "how much cash do you want to have left in the bank?"

Knowing this number will help you know your limits when deciding on what renovations you're willing to pay for. Renovating a home comes with many unexpected expenses. Knowing your bottom line and how much cash you need in your reserves to feel secure will protect you from wiping out your savings with home repairs and renovations.

Can you afford your dream home? Use this calculator to find out:

4. Consider all funding options.

Home-renovation loans are an affordable way to make home renovations, but they are not the only option.

Think of it this way: For every $10,000 in renovation costs added to a loan, the borrower will pay between $45 and $55 per month.

Home-renovation loans usually have a lower, fixed interest rate, as opposed to a home equity line of credit (HELOC), which fluctuates against prime interest rates. Using a HELOC is a good alternative, though, if you can't afford home renovations out of pocket and don't want to use a reno loan, simply because they are more affordable than personal loans as they are borrowing against your existing equity.

As for other options, Boneparth advises staying away from consumer debt like credit cards when budgeting for your renovations.

5. You have to use a licensed contractor for any structural, electrical, or plumbing renovations when using a home-renovation loan.

That's because, until the loan is paid off, the bank wants to ensure that its assets are being repaired responsibly to mitigate any risks or depreciation due to renovations gone wrong.

This means you won't be able to call upon your handyman friends come in to do the job unless they are licensed by your state and insured. The only exceptions are for projects like painting, hanging ceiling fans, and other small upgrades. Be sure to budget for a certified contractor for projects like electrical work, French drains, HVAC, etc.

6. You'll need a feasibility study prior to having the home appraised.

For the price of roughly $300 - though it will vary depending on your location - a person called a 203k consultant will come and inspect your home before you buy it. Their purpose is to give a third-party estimate of both required and suggested renovations before you have your formal appraisal.

You'll need to cover this out-of-pocket expense, but in the grand scheme of things you could be saving yourself costly surprises in the future. A feasibility study will help you determine whether your vision aligns with how much loan you'll qualify for, and whether you can proceed with the purchase.

Are home-renovation loans worth it?

Home renovation loans are a good option for people who have some design knowledge, technical know-how, and, most of all - patience.

Gage has seen customers gain more equity once they looked past ugly mint green and dusty mauve walls, outdated carpeting, and pepto-pink bathrooms. She says the renovation loans she has closed show a higher appreciation rate after six to 12 months compared to other home loans.

For example, her most recent client purchased their fixer-upper at an as-is price of $321,500 and financed around $65,000 in renovations. Their after-improved value came back at $450,000. So, while they only put down 3.5% of the total acquisition cost, the buyers grew their equity by 15% in three months.

Of course, results will vary based on improvements made during renovations, the timing of the sale, and the market you're in. While reno loans offer the potential for fast equity, it doesn't come without risk.

Related coverage from How to Do Everything: Money

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