Construction loan vs. HELOC: which is the better option?
A HELOC is a type of second mortgage that a borrower may qualify for based largely on the equity in their existing home. Once the loan closes the borrower receives a line of credit that can be used for any type of expense, including home improvements, paying down debt such as large medical bills, paying for college tuition, etc.
A construction loan is exclusively created for building a new home from the ground-up to making major renovations on a home.
Read on to learn more about choosing a construction loan or a HELOC.
At Credit Union of Southern California (CU SoCal), we make getting a Home Equity Line of Credit (HELOC) easy.
Call 866.287.6225 today to schedule a no-obligation consultation and learn about our home equity lines of credit, auto loans, personal loans, checking and savings accounts, and other banking products. As a full-service financial institution, we look forward to helping you with all your banking needs.
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What is a HELOC?
A
Home Equity Line of Credit (HELOC) is a type of “revolving” credit, similar to a credit card. HELOCs come with a credit limit based on the amount the borrower is approved for. During the "draw period,” a variable interest rate is charged on the amount of the loan that's used. The draw period is followed by a repayment period when the loan converts to a fixed interest rate.
There are
HELOC pros and cons to consider. One of the advantages of a HELOC is that you can take out money as you need it, and you will only pay interest on the amount you use. However, because a HELOC is a type of
second mortgage and is secured by your home, if you do not repay the loan, the bank can foreclose.
What is a Construction Loan?
According to the
Consumer Financial Protection Bureau, a construction loan is usually a short-term loan that provides funds to cover the cost of building or rehabilitating a home.
In general, construction loans have higher interest rates than longer-term mortgage loans used to purchase homes. The money borrowed through a construction loan is typically provided in a series of advances as the construction progresses. Payments sometimes start on a construction loan six to 24 months after the loan is made.
You can pay off the balance in a lump sum or you may be able to convert the loan to a conventional mortgage loan, though if your construction loan does not automatically convert you may have to reapply for a new loan. Your choices will depend on the lender and your credit history when you apply, so make sure to compare multiple loans, terms, and features.
There are several types of construction loans to consider, including:
Construction-to-permanent loan. This loan is for building a new home and allows the loan amount to be converted to a traditional permanent mortgage. The benefit is you will not need to apply for a second loan to repay this loan.
Construction-only loan. As the name states, this loan is only for constructing the new home and does not cover financing the repayment of that loan.
Renovation construction loan. There are several types of renovation loans. These loans can be used by homeowners who want to make renovations to their current home or homebuyers who want to purchase a fixer upper. One example is the Fannie Mae HomeStyle Renovation loan. The U.S. Department of Housing and Urban Development (HUD) also offers 203(k) loan programs for the major rehabilitation and repair of single-family properties.
How do HELOCs and Construction Loans Compare?
Here are some of main features to consider when comparing a construction loan vs. HELOC loan:
Interest rates
HELOC: Typically starts with a variable interest rate that stays in effect during the draw period and adjusts to a fixed rate during the repayment period. Interest is charged on only the amount of the loan you use.
Construction loan: Like HELOCs, construction loans have a variable interest rate with an interest-only repayment phase. Interest is charged on the amount of the loan used.
Rates may be higher than HELOC rates.
Spending flexibility
HELOC: Funds can be used any way you choose.
Construction loan: Funds must be used for the designated construction project for which the loan is granted.
Funding
HELOC: Borrower receives a line of credit from which they can withdraw funds.
Construction loan: Funds are released in stages as each phase of construction is completed.
Terms
HELOC: Typically has a 10-year draw period and a 15- or 20-year repayment period.
Construction loan: Depending on the loan and the type of construction project, these loans are typically from six months to two years, during which the project must be completed.
Collateral
HELOC: A HELOC uses your home as collateral.
Construction loan: No collateral needed. Qualification is based on the borrower’s credit score.
Loan term
HELOC: Long-term loan that typically has a 10-year draw period and
Construction loan: A construction loan ends when the project is complete, and a certificate of occupancy is issued by the municipality in which the home is built.
Tax benefits
HELOC: HELOC interest is
tax deductible only if the borrowed funds are used to buy, build, or substantially improve the taxpayer’s home that secures the loan.
Construction loan: According to the IRS, some loan interest may be deductible once construction begins. You can treat a home under construction as a qualified home for a period of up to 24 months, but only if it becomes your qualified home at the time, it's ready for occupancy. The 24-month period can start any time on or after the day construction begins. As a qualified home, the interest paid may qualify as deductible mortgage interest, with certain limitations.
Repayments
HELOC:
HELOC repayments have two stages. All HELOCS have a “draw period” (typically 10-15 years) and a “repayment period” (typically up to 20 years). During the draw period, you can borrow as much of the funds as you need, and repayments are made based on interest-only. After the draw period ends, the HELOC repayment period begins. At this time, most HELOC interest rates will adjust to a fixed rate and monthly payments will include both principal and interest on the outstanding balance.
Construction loan: May be repaid as part of a construction-to-permanent loan or paid after the project is completed by obtaining a new mortgage or paid-off with cash.
Eligibility requirements
HELOC:
A good repayment history on your current mortgage and other loans or credit, a minimum credit score of 620, sufficient income to repay the loan, and 15-20% home equity are some of the HELOC eligibility requirements.
Construction loan: Most lenders look at the borrower's
credit score and debt-to-income ratio (DTI). The credit score requirement will vary depending on the lender and the type of loan program.
When does it make sense to get a HELOC?
If you need money for a major renovation project and already own a home, you have the flexibility to choose between a HELOC vs. a construction loan. However, getting approved for a HELOC requires sufficient home equity, a good credit score, and an appraised home value that produces a favorable loan-to-value ratio for the lender to do the loan. In other words, applying for a HELOC has more requirements than applying for a construction loan.
When is a construction loan better?
A construction loan will be your only option if you do not already own a home and therefore don't have home equity on which to base a HELOC. If you do own a home, a construction loan provides a direct path to borrowing money for a specific project, be it a large renovation or construction of a new home. Because the funds from a construction loan can only be used for the designated project, you cannot use the money for other purchases and your project will stay on track.
HELOC and construction loan alternatives
Exploring all loan options before you commit to a specific type of loan can save you money and save and headaches and financial upset that could result from selecting the wrong type of loan. Here are some other funding sources to consider.
Home equity loan. Like a HELOC, a home equity loan is a type of loan based on the equity in your home. These loans have a fixed interest rate for the duration of the loan term. Interest is charged on the entire loan amount, whether you use the money or not.
Cash-out refinance. Getting cash-out during the refinance of your mortgage means borrowing more than what you owe on your current mortgage and getting a cash disbursement of the extra funds at closing. You can use the cash any way you choose. Refinancing your current mortgage to a new mortgage could help you lower your monthly payments, if you can get a lower interest rate than you currently have.
Personal loan. Credit unions and banks offer a wide variety of secured and unsecured personal loans to meet a wide variety of borrowing needs. You’ll find variable and fixed rate personal loan options.
Why Savvy Consumers Choose CU SoCal
For over 60 years, CU SoCal has been providing financial services, including HELOCs, car loans, personal loans, mortgages, credit cards, and other banking products, to those who live, work, worship, or attend school in Orange County, Los Angeles County, Riverside County, and San Bernardino County.
Please give us a call today at 866.287.6225 today to schedule a no-obligation consultation with one of our HELOC experts.
Get Started on Your Home Equity Line of Credit Today!