How do home renovation loans work?
If you’re considering a renovation loan for a home upgrade, refinancing your existing home loan can be a smart way to do it. Essentially you’re ‘topping up’ your loan to borrow the extra money to finance the reno.
It’s generally only possible if you have enough equity in your property, but most borrowers who have had their loan for a few years should be in a position to draw down some equity.
Equity just means the difference between your loan amount and what your property is worth. For renovations, most lenders will allow you to extend your total loan balance to up to 80% of your property’s current value.
So let’s say your current home loan balance is $700,000 and your property is worth $1,000,000. You may be able to cash out an additional $100,000, bringing your new loan total to $800,000, or 80% of the property’s current value. The extra $100,000 becomes your renovation loan to finance your home improvements.
Note, it may be possible to borrow more than 80% of your property’s value in some cases. But if your loan-to-value ratio (LVR) goes above 80%, you may need to pay for lenders mortgage insurance, which would significantly add to the cost of your reno.
On average customers who refinance their mortgage through Money.com.au have around $345,000 in usable equity that they can potentially access for renovations or other purposes.
Structuring your loan to suit your renovation
There are two main ways you could structure your home renovation loan once the lender has agreed to lend you the extra funds.
Top-up
This involves a straightforward increase to your existing home loan with the reno funds added to your balance.
Loan split
Separate the extra funds into a dedicated renovation home loan account, with interest-only repayments.
Money.com.au Mortgage Broker, Nick Burgess, explains that the separate renovation loan split is what most borrowers choose once he explains how this works and the flexibility it offers.
“When they come to us, a lot of borrowers aren't aware that they can create this separate loan for the renovations and set it up with interest-only repayments,” says Nick.
“The benefit, particularly for bigger renos, is that the funds can just sit there until the homeowner is ready to actually start building. Because it’s interest-only, there are no repayments on that debt until they use the cash and interest starts accruing."
Why clients often choose a split renovation loan
Nick Burgess, Money.com.au Senior Mortgage Broker
“The reason this works well is a lot of borrowers don't know when exactly they're going to start the renovations. They might be trying to find a builder and the start date could be six months away.
In the meantime, the funds for the reno just sit there ready to go with no repayments required. If, on the other hand, the renovation loan was on principal and interest, as soon as that money hits the borrower’s account, they've got a minimum repayment to make to the bank.
That means the budget available for the reno is going to keep dropping down with each repayment. So if they're budgeting a certain amount for the reno, that may not be the best way to structure the loan.”
Nick Burgess, Money.com.au Senior Mortgage Broker
Benefits of the right renovation loan
Let’s use the example of that extra $100,000 borrowed for renovations, where the building work doesn’t commence for six months. The renovation loan funds go into a separate interest-only loan account with the balance fully offset using an offset account or redraw facility until the building starts. Because of this, the borrower doesn’t need to pay anything until the funds are drawn down.
In an alternative scenario, had those funds simply been added to the borrower’s existing balance (with principal and interest repayments), their monthly loan repayments would have increased by $644 per month*, or an extra $3,864 over six months. That amount would include $3,000 in interest payable on the renovation funds before any work is done, with $864 of the loan paid back.
Starting to repay the extra renovation loan funds from day one is not ideal for two reasons:
- You’re depleting your renovation funds i.e. paying the money back to the bank before you’ve used it.
- Unless you can keep the money in an offset account or redraw facility, you’re paying interest on the amount you borrowed.
If your loan doesn’t have an offset account or redraw, you could always stash the money in a high interest savings account until you need it to pay your builder, but the separate loan is often a cleaner solution. That said, it’s worth discussing this strategy with a mortgage broker and how it might apply to your situation.
*Assumes a 6% p.a. interest rate and 25-year remaining loan term.
Case study: Renovation refinance
Money.com.au’s Editor, Sean Callery, explains how he refinanced his mortgage to fund a home renovation project.
“We had two bathrooms badly in need of a complete remodel and some equity in our property to play with, so we decided to refinance our home loan and cash out the money to pay for the work.
Here’s what we did step by step:
- We decided on the scope of the project and got three builders to quote for the work, then chose a builder and paid a deposit to secure a start date.
- With a budget locked in, we talked to our lender about our plans and how much we needed.
- We went through a fairly thorough refinance loan application where the lender assessed our income, bank statements and other loans and credit cards.
- After a few days, the finance was approved and about a week later the funds for the reno were paid into our offset account.
- As it happened, we had some cash available to redraw from our existing loan, so part of the reno funds were simply paid back to us using that money. This reduced the amount of new borrowing.
- We used the loan funds to pay the builder as the invoices came due. There was a bit left over and we resisted the temptation to keep buying expensive bathroom accessories and instead paid that money back into the loan to lower our balance and save on interest."
Et voila! Before and after…
The main complication with our home renovation loan
Sean Callery, Editor
"To throw a slight spanner in the works early on, one of the builders we spoke to insisted that due to the high demand for their services, they would only quote on jobs if there was renovation finance approved and ready to go.
This was our preferred builder, so I explained that we needed to establish our budget before approaching our lender and thankfully they were flexible. But it’s a good reminder that there can be a chicken-and-egg scenario in terms of which should come first: establishing the budget for the renovation by getting builder quotes, or establishing the budget for the renovation by seeing what a lender will give you.
The reality is some builders won’t give a quote without finance, and some lenders won’t give finance without a quote."
Sean Callery, Editor
How to qualify for a loan for renovation
To qualify for a renovation refinance, these are the main criteria that apply across Money.com.au’s panel of lenders:
Do you have enough equity?
You’ll need to have enough usable equity in your home to borrow against. For most lenders, your total loan balance (including the extra renovation loan funds) can be a maximum of 80% of your property’s current value. In other words, your current loan will need to be less than 80% in order for you to be able to borrow more.
What’s the value of your property?
To assess your borrowing capacity, you’ll need to have your property valued by the lender. In a lot of cases, this involves a simple ’desktop’ valuation where the lender uses online resources to estimate your property’s value. For more complex applications a physical inspection of your property may be ordered.
Is the reno structural or non-structural?
The lender will want to know if the renovations are structural or non-structural. For non-structural upgrades (e.g. remodelling a kitchen or adding a pool), a simple loan top-up may be all that’s needed. If it’s a structural upgrade (e.g. adding an extra floor), you’ll likely need a construction loan instead.
Are you an owner-builder?
The lender will want to know if you’re doing the work yourself (or project managing it yourself) or working with a separate builder or project manager. In most instances, lenders are reluctant to lend to owner-builders for renovations as they view this as being riskier.
Can you service the loan?
The lender will also assess your current income, expenses and other debts to ensure that you can service (i.e. afford) the higher repayments on the loan with the extra reno funds added to it.
How we got a recent client approved when his bank said ‘no’
Nick Burgess, Money.com.au Senior Mortgage Broker
"A client came to us looking for help with a $60,000 cash out for a reno after his original lender said no. The lender was undervaluing his property based on an automated valuation and he was stuck. So I approached three other lenders on the client’s behalf and ordered valuations on the property. The valuations came back higher than what the original lender was quoting, putting my client in a much stronger equity position and we were able to get his renovation refinance approved."
Nick Burgess, Money.com.au Senior Mortgage Broker
