“Home equity loans are based on your home’s current equity, while construction loans are based on the future value of the home; [it’s] financing based on the new-home value when the construction is done,” Melissa Cohn, regional vice president of William Raveis Mortgage, told The Balance by phone. These two loan products have differing qualification requirements, and once you’ve qualified, your costs for each also will vary. Choosing the right loan for you will hinge on how much home equity you have in your current residence, how much you need to finance for your upcoming build, and your preferences for things like fixed or adjustable interest rates.
What’s the Difference Between Construction Loans and HELOCs?
Construction loans are another avenue for anyone who wants to build new construction or undertake a major home renovation but doesn’t have home equity yet. The idea behind these loans is that the future home or modified home will create the secured value for the costs incurred. Your lender will look at specifications and plans, including budgets, for the building project, and will evaluate how likely the home is to offer the value needed to secure the loan. Once this evaluation is made, lenders either may deny the loan or extend it with a variety of interest rates, all based on how risky they perceive the loan to be.
Closing Costs
With construction loans, there typically are higher closing costs than those associated with a HELOC. Construction loans can be structured as a very short-term loan that converts to a mortgage, or as a standalone loan that is repaid with the initiation of a mortgage. Creating that mortgage requires costs such as an origination fee.
Which Loan Is Right for Me?
The structural differences between the two products are the basis for the collateral amount—the future value of the project for the construction loan, and the present value for a HELOC. Also, it’s up to the bank’s discretion how funds are used for a construction loan, while it is up to you how to use a HELOC. The easiest way to make the decision is to determine whether you have enough home equity to qualify for the appropriate size of HELOC that you need for your project. If you don’t have that equity yet, a construction loan of some kind is going to be your best bet. Shop around and figure out if your particular project merits an all-in-one construction loan or a standalone loan that is paid off by taking out a mortgage after completion of the project. For one thing, Cohn said, a construction loan is often a set sum, which you start accruing interest on immediately, while a HELOC’s interest costs only are charged for the amount of the line of credit you actually use at a given time. HELOCs often have lower closing costs than construction loans as well.
A Best-of-Both Worlds Option
If you have adequate home equity for a HELOC to fund your project but want the fixed interest rate and fixed monthly payments that the construction loan would have, a home equity loan may be a third option. It combines the lower closing costs and home-equity-based interest rates of a HELOC with the fixed interest rate that comes with a loan, rather than a line of credit. That said, not everyone has the home equity to secure a loan the size they need for major construction, so each of these three options can offer benefits for different kinds of borrowers.
The Bottom Line
When shopping for a loan to finance a sizable remodeling project, you have to evaluate borrowing costs. A HELOC will offer better closing costs; often a low, if variable, interest rate; and the flexibility to use as much or as little of your credit limit as needed at a given time, allowing for unexpected changes to your expenses. If you don’t have the home equity to make a HELOC possible, or you desire a fixed rate that you can pivot into a long-term home mortgage, a construction loan helps you turn that dream remodel or house into a reality, even if the costs are usually higher. In either case, talking to multiple lenders will help you find which lender offers the most competitive rates and closing costs for your particular circumstance.Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
