Financing Your Home Addition: 4-Step Guide for Homeowners

In the U.S., additions cost homeowners an average of $46,000, with some projects totalling as little as $21,000 and others as much as $73,500 (or more, depending on the selected materials, fixtures, finishes, etc.).Citation Even on the lower end of the scale, the cost is considerable, meaning that most people will need to seek some sort of financial assistance to foot the bill.

Some of the additions that tend to fit into this price range include:

• Traditional or full additions — These involve adding new rooms or spaces to your home to increase its living area.
• Micro additions — The least disruptive option on this list, these additions typically focus on expanding the size of a single room that’s already a part of your home’s floor plan.
• Story additions — As this type of addition adds an extra story (typically a second story) to the top of your house, these are one of the most involved additions you can choose.
• New structures — These include pool houses, greenhouses, detached garages or any independent structure added to your property.
• Garage conversions — While not technically an addition, converting existing garage space (whether fully or partially) into living space increases your home’s liveable area.

If you’re considering an addition for your home, it’s likely that you’re anxious to get started. But before you call the contractor, there are four important tasks you’ll need to cross off your to-do list. Prior to breaking ground, you should:

1. Determine how much your addition will cost. Once you know how much the project will cost in total, you’ll be able to estimate the amount you’ll need to borrow from your lender. Additionally, you can use this figure to get a general idea of how high your monthly loan payments could be.
2. Check your credit score. The higher your credit score, the better your chances are of getting favorable loan terms and interest rates. Checking your score ahead of time can give you an opportunity — if needed — to improve it before applying for a home addition loan.
3. Secure financing. Once you’ve started work on your home addition, it may become difficult to find financing. Your options for securing a loan mid-project may be fewer, less desirable or non-existent as many lenders are unwilling to take on the extra risk.
4. Get any/all necessary building permits. When taking on a project that increases the value or alters the footprint of your home, you’ll most likely need to get a building permit from your local municipal offices. Failing to do so may result in stalled progress or canceled work and difficulties selling your house in the future.Citation

When it comes to finding the financing you need to get started, you have options. To help you narrow down your choices and get the ball rolling on your addition more quickly, we rounded up seven different ways of funding your project.

As you go through the following list, consider your situation carefully. You may find that there are only one or two options that make sense for you, and that’s ok. Putting an addition on your home is a major financial decision, so it’s crucial to find the home addition loan type that works best with your circumstances.

Common ways of financing a home addition include:

1. Home Equity Loan

A home equity loan is a type of second mortgage that enables you to tap into the equity you’ve built in your home by making your original mortgage payments.Citation Taking out this type of loan converts that equity into cash which you can then put toward your home addition. Once you have your cash in hand, you’ll pay it back to your lender by making monthly payments (including interest) over a predetermined time period, generally anywhere from five to 30 years.

For the best chance of qualification, it’s recommended that you have more than 20% equity in your home, a credit score that’s greater than 620 and a debt-to-income ratio of less than 43%.

Not sure if this is the right option for you? Try weighing the pros and cons:

2. Home Equity Line of Credit (HELOC)

A HELOC is another way you can finance your addition through the equity you’ve built in your home. Like its name implies, you’ll access funds through a credit line instead of receiving a lump sum of cash. Once approved, you’ll enter into the “draw period,” a five- to 15-year timeframe during which you can use your allotted funds. Then, once the draw period closes, you’ll move on to a “repayment period” where you’ll make payments (with interest) on the amount you spent.

As a similar type of second mortgage, eligibility requirements for a HELOC are similar to what you’ll need to qualify for a home equity loan. To get approved for a home equity line of credit, you should have at least 15% to 20% equity in your home, a minimum credit score of 620 (though 680 is preferred by many lenders), proof of sufficient income and a debt-to-income ratio of 43% or lower.

Pros and cons include:

3. Cash-out Refinance

If you’d prefer to avoid taking out a second mortgage on your home to fund your addition, cash-out refinancing could be a good alternative. This type of mortgage enables you to refinance your original mortgage for more than you currently owe and receive the difference as a lump sum of cash. However, there are limits to how much you can borrow, with most lenders capping the figure at 80% of your home’s appraised value.

To qualify, you’ll generally need to have a credit score of at least 620, a debt-to-income ratio of less than 45% and at least 20% equity in your home. Additionally, if you currently have a conventional mortgage, you’ll need to have owned your home for at least six months before applying for a cash-out refinance.

As always, it’s important to consider both the benefits and drawbacks of this option before making a final decision. These include:

4. Personal Loan

As all of the options we’ve discussed so far require borrowers to have a certain amount of equity in their homes to qualify, a personal loan can be a viable option if you don’t meet that requirement.Citation These loans are straightforward in premise — you’ll borrow a certain amount of money from a lender and pay it back in monthly installments over a term that can last anywhere between one and seven years. There are two types of personal loans: secured and unsecured. Secured loans are backed by a form of collateral and as such, come with lower interest rates. Conversely, unsecured loans don’t require collateral but carry higher interest rates as a result.

To qualify for a personal loan, you’ll need to provide proof of income and have a debt-to-income ratio of 35%. To get the best rates, you’ll need a credit score of 670 or above, but there are some lenders who will approve applicants with subpar credit. Lowering your debt-to-income ratio and applying with a co-signer can also help you improve your chances of getting approved for a personal loan.

Finally, consider the pros and cons:

5. Personal Line of Credit

All in all, a personal line of credit works like a HELOC, with the main difference being that this type of loan isn’t backed by a borrower’s home.Citation Personal credit lines are most frequently offered by banks and credit unions, and once approved, you’ll have access to a certain amount of money that you can use as needed to pay for the work on your home. Like other loans, you’ll pay back what you spend with interest.

Exact eligibility requirements vary by lender, but you can generally expect to need a good or excellent credit score (690 or above) and a credit history that demonstrates responsible spending habits.

Pros and cons include:

6. Saving

While not technically a traditional financing technique, using cash is the least risky method of paying for your addition. If the renovations you’re planning are significant, this option may not be realistic as it could take too long to save up enough money to cover the full cost. However, before exploring other funding options, it doesn’t hurt to spend some time figuring out whether using savings to pay the renovation bill is a possibility.

When it comes to affording your home addition, you have options. If you need assistance narrowing them down, the team at Blue Water Mortgage is here to help. Contact us today to learn about the different financing options we offer so you can get your project started as soon as possible.

Our Mortgage FAQs eBook is another great resource for getting the answers to all of your home loan questions. Download your copy today to brush up on everything from mortgage basics and common loan types to rates, the entire loan process, refinancing — and much more.