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image of a kitchen transposed with the wood framing of an additional room attached to the kitchen representing a home addition

Financing Your Home Addition: 4-Step Guide for Homeowners

Whether you have a growing family, are preparing for an elderly parent to move in with you or are expanding an existing room to accommodate your favorite hobby, there are several reasons why you might be considering adding square footage to your home. No matter your reason, deciding to take on a home improvement project of this scale comes with certain questions that need to be answered — such as “who will do the work?”, “What will the budget be?” and “How will I pay for this project?”.

Because home additions are one of the most significant types of renovation, they’re also one of the most expensive, meaning that the matter of affording the project is a top priority — especially if your savings aren’t where you’d like them to be. So how can you pay for your addition? The good news is that financing options are available.

Keep reading to discover everything you need to know about financing a home addition, including the types of projects that are most frequently financed, what to be aware of before you get to work and different ways to afford the bill.

Home Addition Types That Need Financing

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.). 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.

What to Know Before Starting a Home Addition

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.

Financing a Home Addition: 6 Ways to Afford Your Project

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. 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:

Pros of a Home Equity Loan Cons of a Home Equity Loan
  • Fixed rates mean predictable monthly payments
  • Interest rates are typically lower than a personal loan
  • You won’t lose the rate on your original mortgage, which is good news if it’s low
  • Greater borrowing potential
  • As you’re using the loan for home renovations, the interest may be tax deductible
  • Home equity loans are secured, meaning your house is used as collateral
  • Depending on the value of your equity, the amount you’re able to borrow may not be enough to cover all building expenses
  • You may be on the hook for closing costs
  • Home equity loans are second mortgages, meaning that they must be paid in addition to your original mortgage
  • Not an option if you have less than 20% equity in your home

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:

Pros of a HELOC Cons of a HELOC
  • Potential for lower overall cost — you only repay the amount you spend during the draw period
  • Rates are typically variable, which means lower interest payments if the market is favorable
  • Provides an opportunity to improve your credit
  • Interest may be tax deductible
  • Your house is used as collateral
  • Depending on the amount of equity you have, your available funds may not cover the full cost of your addition
  • Loss of equity in your home
  • Risk of amortization
  • Not an option if you don’t have enough equity

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:

Pros of a Cash-out Refinance Cons of a Cash-out Refinance
  • Potential to lower your interest rate
  • Not a second mortgage, meaning you’ll only have to make one loan payment each month
  • High borrowing potential
  • Can be used to build credit
  • Risk of foreclosure if you fall behind on repayment
  • Could extend the repayment period, meaning you’ll pay more in interest over time
  • You’ll be responsible for closing costs, which can total between 2% and 6% of the loan
  • Securing the loan can take a while, which might not be ideal for your project timeline

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. 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:

Pros of a Personal Loan Cons of a Personal Loan
  • Approvals generally come quickly
  • Collateral is optional
  • Fixed interest rates
  • Higher interest rates for unsecured loans
  • May come with high fees and penalties
  • Strict eligibility requirements
  • Adds an extra monthly payment

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. 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:

Pros of a Personal Line of Credit Cons of a Personal Line of Credit
  • Flexibility — money can be withdrawn when and as you need it
  • No collateral required
  • Possibility for same-day approval and access to funds
  • Interest doesn’t accrue on unused funds
  • May come with fees for origination, withdrawals, maintenance and late payment
  • Qualifying may be difficult
  • Interest is not tax deductible
  • Variable interest rates

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.

Find Financing for Your Home Addition with Blue Water Mortgage

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.

YMYL References:

Roger Odoardi

Roger is an owner and licensed Loan Officer at Blue Water Mortgage. He graduated from the University of New Hampshire’s Whittemore School of Business and has been a leader in the mortgage industry for over 20 years. Roger has personally originated over 2500 residential loans and is considered to be in the top 1% of NH Loan Officers by leading national lender United Wholesale Mortgage.

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