Real Estate Home Finance

How to Finance a Home Addition: 11 Steps to Unlock the Funds to Expand Your Space

Finding the right financing is an important step in any home improvement project. From contractor funding to home remodeling loans, homeowners questioning how to finance a home addition may find the answers they seek in this step-by-step guide.
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There are many reasons a homeowner may find themselves in need of additional living space. Perhaps their family is growing, they need space for an aging parent, or they have recently started working from home full-time and need a dedicated office space. But while some homeowners may see this as an opportunity to upgrade to a larger property, others may prefer to remain in the space they have worked hard to turn into a home.

Those who aren’t willing to part with their home may be drawn to the idea of a home remodel or addition, but with any major home improvement, homeowners will need to be prepared to consider several factors before they can break ground on their project—including how to cover their home renovation costs. To simplify this complex undertaking, homeowners can begin with reviewing this step-by-step guide on how to finance a home addition.

Before You Begin…

Although adding an addition to a house can be an expensive endeavor, in the long run, this investment may be well worth the cost for many homeowners, increasing the overall value of their home.

Still, in the short term, homeowners will need to find a way to pay for their home addition costs. There are many ways to finance a home addition, but before homeowners can choose a financing option, they will need to understand several elements, including the health of their finances and the scope of their project.

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STEP 1: Make a budget based on the type of home addition you want to build.

Home additions have an average cost of around $50,000, though house extension costs can vary significantly depending on the size and complexity of the addition. To calculate expected costs and set a budget, homeowners will need to decide on the type of home addition they wish to build. There are several types to consider, ranging from one-room, bump-out additions to conventional full-size additions.

To choose the right type of home addition, homeowners will need to consider the intended use of the space as well as any construction limitations that may impact the scope of their project. For example, homeowners who lack the space to expand outward may instead decide to build upward with a second story. With these factors in mind, homeowners can get an idea of their expected costs, setting a budget that will make it easier to choose between financing options.

STEP 2: Check your current finances to get an idea of the types of financing you could qualify for.

Before they can compare banks, lenders, and other forms of financing, homeowners will also need to assess the health of their finances. Qualifying for the loan options in this article will require homeowners to meet certain standards, including income, credit score, and debt-to-income requirements.

To get an idea of the financing options that may be available to them, homeowners will need to closely examine each of these factors. They will also want to consider how an additional loan payment might fit into their monthly budget, choosing a financing option that will allow them to access the funds they need without borrowing more than is necessary.

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STEP 3: If you have equity in your home, consider taking out a home equity loan to pay for the addition.

A common option for financing a home addition is with one of the best home equity loans, such as a loan from U.S. Bank or Flagstar Bank. Home equity refers to the amount of the home owned by the homeowner, built up over time through their monthly mortgage payments. A home equity loan is a type of second mortgage that allows homeowners to tap into their home equity and receive a lump sum of cash, making this a popular option for financing home improvements. Home equity loans may also offer more affordable rates than some of the other loans available because the home is used as collateral on the loan, minimizing the lender’s risk.

To qualify, homeowners will need to meet several requirements for a home equity loan. First and foremost, they will need to have a minimum of 15 percent to 20 percent in home equity. Homeowners can assess their home equity by subtracting the amount they owe on their home from the home’s appraised value. This form of financing will also require homeowners to have a debt-to-income (DTI) ratio at or below 43 percent. To calculate their DTI, prospective borrowers can divide their monthly debt payments by their total monthly income before taxes. Finally, homeowners will need a good or excellent credit score to qualify for this loan type, with many lenders requiring a minimum credit score of 620, though exact requirements may vary between lenders.

STEP 4: If you don’t want a lump sum of cash, consider a home equity line of credit (HELOC). 

Homeowners who are unsure of the specific costs they might incur may instead want to consider a home equity line of credit (HELOC) to finance their home addition. Similar to home equity loans, HELOCs allow homeowners to tap into their home equity, though these forms of financing differ in the way homeowners receive and repay their funds. Unlike a home equity loan, which provides homeowners with a lump sum of cash, a HELOC functions much like any line of credit, allowing homeowners to withdraw funds up to a certain amount for a predetermined period of time.

This is referred to as the draw period, which typically lasts around 10 years and allows homeowners to borrow cash as they need it. When the draw period ends, homeowners begin to make monthly payments on their line of credit, with a repayment period typically lasting 20 years in length. This delayed payment schedule is one of the biggest advantages of a HELOC, alongside the flexibility this type of financing can provide. For these reasons, homeowners may want to consider borrowing from one of the best HELOC lenders to finance their home addition.

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STEP 5: Consider a cash-out refinance if mortgage rates are favorable.

Another common way homeowners can tap into their home equity is with a cash-out refinance. Unlike a home equity loan, which is a type of second mortgage that requires homeowners to make an additional monthly payment alongside their primary mortgage, a cash-out refinance allows homeowners to replace their current loan with a larger one, receiving the difference in cash.

However, it’s important to note that a cash-out refinance will alter more than just the loan amount. Interest rates and other terms will also be impacted, which means homeowners will need to pay close attention to the market before pursuing this financing option; otherwise, they could find themselves with less than favorable loan terms. For example, when mortgage rates are high, homeowners with low interest rates will want to avoid a refinance, which would ultimately increase the cost of their loan. But when market rates are low, homeowners who refinance with one of the best mortgage refinance companies (such as PNC or Caliber Home Loans) may be able to lower their interest costs while obtaining the funds they need to finance their home expansion.

STEP 6: If you don’t have home equity to borrow from, look into a home improvement loan or a personal loan to finance the project.

Homeowners who lack the necessary equity for a home equity loan, HELOC, or cash-out refinance may need to consider other loan options, including personal and home improvement loans, to finance their home addition. Personal loans can provide a faster and easier path to financing, though these loans often come with higher interest rates because they are unsecured, unlike many of the other loan options on this list. Still, personal loans may be particularly appealing to homeowners who are uncomfortable with the idea of using their home as collateral.

Another option is one of the best loans for home improvement. Qualifying for these types of loans will typically require homeowners to have good credit history. When comparing home improvement loans, homeowners will want to pay close attention to the annual percentage rate (APR), which is the interest rate plus any fees, expressed as a percentage. Many home improvement loan lenders charge fees, such as origination fees and prepayment penalties, that can add to the total cost of the loan, so homeowners will need to take the time to understand their expected costs before committing to this form of financing.

STEP 7: Check to see if you qualify for a government-backed loan, such as the FHA 203(k) mortgage.

FHA 203(k) loans, also referred to as home renovation loans, allow borrowers to combine mortgage and home renovation costs into one convenient loan. For existing homeowners, an FHA 203(k) loan can be used to refinance a home in need of renovations, making this a feasible financing option for a home addition.  However, it’s important to note that while both labor and materials are covered under a renovation loan, the covered work must begin within 30 days of closing and must be completed within 6 months.

Because these loans are backed by the Federal Housing Administration (FHA), FHA 203(k) loans often come with more flexible requirements than other home improvement financing options. To qualify for this type of loan, prospective borrowers will need a credit score of at least 500 and a maximum DTI ratio of 43 percent. To repay this type of loan, homeowners simply need to make monthly payments on their mortgage. Alongside affordability, this is the ultimate appeal of an FHA 203(k) loan: convenience.

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STEP 8: Consider using credit cards strategically or taking out a personal line of credit to cover the home addition costs.

To finance smaller, simpler additions, homeowners may be able to turn to traditional credit cards. Some credit cards may even offer cash back and other rewards to sweeten the deal, allowing homeowners to maximize on their home improvement spending. However, homeowners who pursue this form of financing will want to be mindful of interest charges, which can be significant. To avoid paying more than is necessary for their renovations, homeowners who pay with credit cards will need to prioritize paying their balance in full at the end of every month; otherwise, they could find themselves facing hefty interest charges.

Personal lines of credit (PLOCs) present another financing option. Much like HELOCs, these revolving credit lines allow homeowners to borrow and repay funds as they need them. However, while HELOCs leverage the home as collateral to secure the loan, personal lines of credit are unsecured, meaning borrowers may need to meet stricter qualification terms. It’s also important to note that the draw and repayment periods on a PLOC will be shorter than what homeowners might encounter with a HELOC, typically lasting between 3 and 5 years each. However, personal lines of credit may be a good option for borrowers who want to avoid using their home as collateral.

STEP 9: A construction loan may be an option to pay for a home addition.

If other types of home improvement loans aren’t the right fit, homeowners may want to consider a construction loan. Although construction loans are commonly used to build new homes, these loans can also be used to finance large home renovation projects. However, it’s important for homeowners to understand that construction loans can be more complicated and costly than other types of loans.

Unlike many of the financing options in this article, construction loans are short-term loans, meaning borrowers will have a shorter time frame to pay off the debt. Construction loans are also financed differently than other types of loans—the contractor is typically responsible for requesting funds as needed from the lender throughout the project. The process for making withdrawals typically requires several steps, including forms and inspections, which may delay the construction of a home addition.

Homeowners considering one of the best construction loan lenders for their home addition project will want to bear in mind that there are several types of construction loans available. The most common is a construction-to-permanent loan, which will help fund the building of the addition and convert into a traditional mortgage once the project is completed. Opting for this type of construction loan gives the homeowner more breathing room when the original loan comes due, since they will make payments on a mortgage like they would with a traditional home purchase. But if the homeowner already has a mortgage, a construction loan will add a separate monthly payment on top of their primary home loan, which could cause financial trouble in the future.

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STEP 10: Some builders and home improvement services may offer contractor financing to help pay for a home addition.

Many of the best home builders and home improvement services may offer contractor financing to help homeowners cover the costs associated with a home addition. Homeowners may choose to consider this financing option for several reasons. First, loan qualification is left up to the contractor, which means contractor financing can be easier to qualify for than traditional loans—a fact that may be particularly appealing for borrowers with a less-than-ideal credit score. Depending on the company, the application process for contractor financing may also be faster and more streamlined than for other financing options, allowing homeowners to break ground on their new project sooner rather than later.

However, there are some important factors for homeowners to consider before pursuing contractor financing. The terms of this type of financing can vary significantly between contractors, so homeowners will need to be sure to carefully review the loan terms, including interest rates, fees, and repayment schedules, before signing on the dotted line.

STEP 11: If possible, pay for some or all of the addition using savings.

Whenever possible, homeowners will want to consider using savings to cover some or all of their home addition costs. Paying in cash for a home addition can allow homeowners to significantly minimize or eliminate their interest costs, which may result in substantial savings over time, especially when compared with extended loan terms. Additionally, paying in cash can help homeowners avoid potentially expensive fees, ranging from origination fees to application fees and late-payment penalties.

While financing a home addition with savings alone may not be feasible for everyone, homeowners who plan ahead will want to prioritize saving a portion of the project cost to reduce their financing needs and reap the reward of long-term savings.

As families grow and needs evolve, many homeowners find themselves considering a home addition. But financing home renovations and expansions will require homeowners to consider multiple factors, ranging from the size and complexity of their plan to the health of their finances.

This means there is no one-size-fits-all answer when it comes to financing a home addition, so homeowners will need to weigh the pros and cons of each option available before choosing the financing that best suits their unique needs.