How do Home Renovation Loans Work?

So, you have found your dream house with potential, but it is not quite how you would ideally like it to be. It is not uncommon for people to walk into a home with broken windows and damaged walls, yet fall in love with it.

Buying such houses might not always be a wise idea, unless you have the finances available to renovate or can secure a home renovation loan. In addition to new purchases, renovation loans can also be suitable for homes you already own.

With more people spending time at home during the COVID-19 pandemic, you may consider upgrading your home and making it into a more comfortable and enjoyable space.

There are a variety of options to consider, such as adding a pool, finishing the basement and turning it into a rec room, building out the backyard, landscaping, renovating a home's interior, etc.

These renovation jobs do not only make the home more comfortable to the current homeowners, but they also increase its worth and make it more attractive to potential buyers.

What is a Home Renovation Loan?

It is a type of loan that often comes wrapped into a mortgage loan to cover the cost of renovating a property. In simple words, it allows homeowners to use some of the equity available in their homes to invest in renovating and improving their homes.

In most cases, you will have to estimate the cost of renovations when you apply for a loan.

If you are a new homeowner, then you may be able to incorporate the renovation costs into the initial mortgage loan. For example, if you are buying a house worth $700,000 and you expect to spend $100,000 on renovations then consider getting a mortgage loan of $800,000 or more. This is called a Purchase Plus Improvement Mortgage. Purchase plus improvement mortgages are great ways to buy the dream home with potential while being able to afford turning it into the perfect dream home shortly after your closing date.

Why Renovate Your Home?

Here are some of the reasons why you should consider renovating your property:

• Give a boost to its value
• Make it easier and faster to sell
• Increase its utility and make it look more attractive
• Make it a more comfortable and enjoyable place to live and work
• Create a secondary stream of income by finishing a basement to rent it out

These days, a large number of Canadians prefer to socialize, work, and relax at home. Renovation jobs offer opportunities to create a property that reflects your true personality and allows you to live the way you want to live.

You can add features that you believe in. These include energy-saving modifications, a patio to enjoy with your friends, and sustainable upgrades to support your sustainable living objectives.

While those points mentioned above can be major benefits of renovations, some people undertake renovations to make their homes more attractive to buyers. Depending on the renovations, and some renovation projects may cost a lot, but they can come with some great benefits.

A small bathroom upgrade can offer a return of approximately 100 percent. Landscaping gives similar returns, and kitchen remodeling provides an average return of 98.5 percent.

This means spending $5,000 on remodeling your kitchen can add approximately $9,925 to the value of your property. In addition to this, carefully performed jobs can even help sell homes faster.

Despite today’s hot real estate market, in many cases, it can take months to find a suitable and qualified buyer in Canada. By adding features such as a finished basement, a pool, or a new kitchen and bathroom, you can make your home more attractive to buyers and sell it faster.

Home Renovation Loan Options

As a homeowner, you can choose from a number of ways to finance your home improvement projects.

For Smaller Renovations:

There are various options for smaller jobs that are usually under $10,000.

1. Credit Cards - Though convenient and easy to get, this option comes with major cons in the form of extremely high interest rates and monthly payments that can have a negative impact on your ability to get loans in the future. Plus, paying the balance can oftentimes require high income and a lot of discipline.
2. Personal Line of Credit - More affordable than credit cards, this option can also have a negative impact on your ability to get loans in the future.
3. Home Improvement Loan - This is one of the best options as it allows you to get your hands on your funds upfront at a good rate. Most loan providers have a structured repayment plan that makes repayment easier. These loans can run for as little as 6 months up to several years, depending on your needs and current financial situation. This flexibility can make them less cumbersome. Plus, a longer payback period can mean lower monthly payments and less of a negative impact on your mortgage qualifying ratios in the future.
4. Deferred Payment Plan - This method is typically used to make big purchases. It is attractive since it comes with no payments or little payments for 1st year, but it can be very expensive in the long run with rates approaching 29.9 percent after the first year.

For Big Projects:

For big jobs, it might be a good idea to borrow based on your existing equity, or the equity created by performing renovations.

In most cases, you will be able to get up to 80 percent of your property’s appraised value minus the balance on your existing mortgage.

Available options include:

1. Home Equity Line of Credit (HELOC) - This works like a personal line of credit and comes with the ease and convenience of flexible payment schedules. However, it can be difficult to qualify for some borrowers.
2. 2nd mortgage - A second mortgage is a loan on your existing mortgage. It is often more affordable than other options and monthly payments have to be paid, in addition to your current original mortgage. While it tends to be more expensive than a HELOC, it is still commonly a preferred option as it offers a structured payment plan and upfront cash. Since the monthly payments are interest only, they tend to be much more affordable than the payments on high interest credit cards, department store cards, and other higher interest loans.
3. Draw Mortgage: Though not very popular, this method can be excellent as it may allow you to get a loan that exceeds 100 percent of your home’s current value. A draw mortgage involves large payments that are received in intervals based on predetermined milestones. You will get money for the next step only when the current stage is completed.
4. Refinance with Equity-Take-Out - This method involves replacing your existing mortgage with a new one at a higher principal balance than is currently remaining on your existing mortgage. This technique provides a lump sum of cash that you can spend as you wish.

Which is the Best Option?

While they all come with their own pros and cons, it might be a good idea to choose the option that lets you take out a short-term second mortgage / home equity loan to complete the renovations and upgrades. Once the updates are complete, you can then refinance your current first mortgage at a higher value (if you qualify) to pay off the home renovation loan and roll it all into one larger 1st mortgage at a much lower interest rate.

The new refinanced amount would be based on the newly appraised value that will take into account the upgrades and potentially add value to your home.

Renovation loans using home equity are usually significantly cheaper than the interest payments on most home renovation store credit cards, many furniture store cards, and many retail store credit cards.

The monthly payments on a second mortgage tend to be lower than many store credit card payments since the payments on a home renovation loan using your home equity is usually interest only payments.

For example, if you take out a $100,000 second mortgage at 8.99%, then your monthly payments will be $100,000 x 8.99% divided by 12. This equals $749.17/month.

Take the same $50,000 on a home renovation store credit card might carry an interest rate of 19% a year with the minimum monthly payment at approximately 3% a month. That means that with a home renovation store credit card, you might be paying as much as $1,500 a month, which in this case is double the monthly payment than a second mortgage to have.

In this, and many examples, the second mortgage provides an easier and more cashflow beneficial option for taking out a home renovation loan.

Repaying the Loan

It is important to keep track of your monthly payments and ensure that you take all the steps necessary to repay your debt within the agreed time frame. Try to keep the renovation as small as possible while ensuring that you have enough money to complete the renovation. I do not suggest undertaking projects that are ‘too big’ for you and your budget. Understand that you will need to be disciplined to make these payments in a timely fashion, and to be able to eventually repay the entire principal of the loan in the event that you may not be able to qualify for a refinance of your current 1st mortgage with an equity take out to pay off the principal on the 2nd mortgage.

Taking out a fixed amount is a lot better as it helps to ensure that you do not go overboard with your renovations. Think of a renovation job that you expected would cost only $2,000. Let’s say you chose to use your credit card for ease, only to realize that you ended up spending $5,000 because you had the extra room available on your card. That’s more than double the amount you originally calculated, and a decent amount of the extra budget may seem like a waste to you in the end.

Paying this balance can be a lot of trouble, especially if you never took it into account when calculating your monthly budget to service the loan. A structured plan before commencing renovations will help make things easier. A second mortgage can help with this as it is presented in the form of ‘fixed installments’.

You will know exactly how much you will have to pay per month and your mortgage broker can help you come up with a realistic plan to repay and get rid of the debt altogether. The interest rate and other such factors often vary from mortgage provider to provider. Some 2nd mortgage lenders are more affordable than others, and some can be difficult to work with. Nonetheless, most would require a detailed explanation of the job you wish to perform and the results you expect prior to granting you the loan.

Please use our simple home equity calculator to find out how much you can get out of your home in the form of a second mortgage loan. Also, you can get in touch with a mortgage agent to have a conversation about renovation home loans.