Money Moments: How to finance a home addition

October 06, 2022

Whether you’ve just moved in or have lived in your home for years, it’s natural to want to make the space your own. Perhaps you’ve dreamt of a small bathroom or kitchen remodel, or a large-scale project, such as adding a mother-in-law apartment.

Before hiring a contractor and drawing up plans, it’s important to think about how you’ll pay for labor and materials. Luckily, you don’t have to have every penny saved in the bank. In fact, there are many ways to get creative when it comes to bankrolling home projects.

Home equity line of credit

Often called HELOC, this type of financing can be a first or second mortgage that taps into the equity you’ve earned. A quick calculation: take the current value of your home and subtract how much you still owe on the mortgage. The difference is your equity. With a HELOC, you can borrow against a percentage of that number at a variable interest rate.

The funds are made available in the form of a revolving line of credit, similar to a credit card. Typically, you can access available funds at any time for whatever you need over a draw period of 10 years. During this time, minimum payments are low, and may only include payments on the interest for those that qualify. That changes in the repayment period, when the principal and interest are lumped into a monthly payment – usually over 20 years.

A HELOC is a great option if you need a surplus of money that’s flexible in terms of how and when you use it. But, you need to be cautious when putting your house up as collateral. If you fail to make payments, the bank could seize your house.

Home equity loan

As the name suggests, this type of financing also accesses your home’s equity through a second mortgage. Unlike a HELOC, a home equity loan is given as a lump sum of money. It is a percentage of your home equity with a fixed interest rate, but there is no draw period. You must begin making the monthly payments as soon as you take out the loan.

If you know the amount you need for a specific home project and want steadier financing, a home equity loan may work. But remember, you’ll still be using your house as collateral, so making monthly payments on time is key.

Cash-out refinance

If you don’t want a second mortgage, there’s another option that relies on home equity to pay for renovations: refinancing. This method involves replacing your current mortgage with a new one that’s greater than what you owe on the house. (It’ll also have a new interest rate and term length.) The difference between what you owe and the new mortgage amount is how much cash you can use.

Refinancing is an ideal strategy for homeowners looking to possibly take advantage of a lower interest rate than their original mortgage.

Personal loan

Not everyone, however, has lived in their home long enough to tap into the equity. If that’s the case for you, don’t worry – other options for financing home projects exist. Taking out a personal loan, for example, is often a simpler and faster route to access cash.

Unlike the paperwork and inspections required for refinancing or obtaining a second mortgage with a HELOC or home equity loan, a personal loan offers a streamlined application process based on basic information, such as your credit history and income.

Personal line of credit

This type of financing is a revolving line of credit similar to a HELOC – except your house isn’t required for collateral. While a personal line of credit functions like a credit card, it typically offers higher credit limits and more favorable annual percentage rates.

Credit card

For one-off projects on the smaller side (think: redoing the tile in your guest bathroom), a credit card may be all you need to make your home renovation dreams a reality. You should pay the balance in full every month to avoid interest charges, which, for credit cards, are typically higher than any other type of financing.

Cash

Of course, paying for home renovation projects in cash is always an option – especially if your credit score is preventing you from accessing lines of credit. It may take longer to save before you can begin remodeling, but zero debt is a positive tradeoff.

Read how one family financed an addition to their home, then learn more about home equity options to assess what may work best for your remodeling goals.

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