How To Finance a Home Addition

Purchasing a home addition not only creates space and adds value, but it provides room for new possibilities.

Perhaps family is coming to stay with you, or your home is feeling a bit cramped. Or maybe you’re in the market for a new home and feel that space would be just perfect with a sunroom.

Whatever the reason, an addition on your home has the potential to dramatically increase its value and change the way you live. But it’s hardly an inexpensive project. It’s important for the way you finance the addition to make sense and meet your needs.

We’ll take you through some of the most common financing options for your home addition. You’ll have all the tools you need to build the right financing plan for you.

When Should I Finance a Home Addition?

Deciding whether or not to put an addition on your home comes down to why you want it, how it will affect your life (both during and after it is built) and how you’ll pay for it. 

Another big factor is how long you plan to live with the addition. In general, it’s best to try and get some use out of an addition before you sell. That is, unless you’re looking to flip your house and the addition will be built to add value. 

Consider these pros and cons of building an addition:

What Type of Addition Are You Planning?

The average price of an addition is around $21,000 – $73,000.^[1] The price depends on the type of addition, build complexity, cost of materials and features included. 

There are several types of additions that can be built. Here are some of the most common ones:

Full addition

This type of addition builds an extra room onto the home. It’s generally the most costly type of addition and may require a host of contractors to install the various elements including HVAC systems, electrical, plumbing, roofing, siding, windows and doors. It can also include adding a foundation or full basement.

Second story addition

If the lot size is small, or you’d like to keep your yard as is, building upward can increase the square footage of your home without affecting its footprint. 

This option tends to be a bit less expensive than a full addition, and can be especially useful when adding extra bedrooms or bathrooms. Many of the same contractors needed for a full addition will be required for this home renovation.

Micro addition or bump-out

A micro addition (often referred to as a bump-out) adds a small amount of space to your home. It’s the least expensive option because it typically doesn’t require additional foundation, electric or HVAC work. They’re great for adding more space to an existing room.

What Kind of Home Loan Can You Get to Add an Addition to Your House?

Depending on the size and projected cost of your addition, you’ll want to explore the options for financing it. There are several types of loans that could fit the bill for your home improvement project – including those that let you borrow from the equity in your home and those that don’t.

How Can You Use Home Equity to Finance an Addition?

Both a home equity loan and home equity line of credit (HELOC) are considered a second mortgage. For either loan, a lender will typically require a minimum of 15% – 20% equity. Most lenders will lend you up to 85% of your home’s equity.

Requirements vary by lender, but for either a home equity loan or HELOC, you’ll need a credit score of at least 620 and a maximum debt-to-income (DTI) ratio of 43%. There may also be fees that can add 2% – 5% to the loan amount.

Home equity line of credit (HELOC)

A HELOC typically has a variable interest rate, meaning the rate can go up or down depending on market conditions. A HELOC is revolving credit, so you only pay interest on what you borrow. 

HELOCs can be well-suited for home renovation projects where the final cost isn’t known upfront, and where parts of the project need to be funded as they occur. A HELOC allows you to borrow what you need as you need it. This is done during the HELOC’s draw period (usually 10 years). The draw period is a time frame, set by a lender, you can withdraw from your available credit.

The loan is then repaid during the repayment period, usually 20 years. And in some circumstances, the interest paid can be tax-deductible.

It can take 2 – 6 weeks from application to approval to get a HELOC.

Home equity loan

With a home equity loan, the lender gives you a lump sum which you pay back, plus interest, over the term of the loan. Home equity loans are generally fixed-interest loans, so the rate you recieve at the start of the loan remains the same until the loan is repaid. These are installment loans with a fixed monthly payment. 

A home equity loan can be great for funding a home addition in circumstances where the costs of the project are known upfront. It’s also nice to have a predictable rate and monthly payment. 

Like a HELOC, approval for a home equity loan will take 2 – 6 weeks and the interest paid on a home equity loan could be tax-deductible.

Cash-out refinance

A cash-out refinance (or cash-out refi) pays off your existing mortgage, gives you back some of your home’s equity and you receive a new mortgage. The DTI and credit requirements tend to be the same as for a HELOC or a home equity loan, but for a cash-out refinance, you’ll need to have at least 20% equity in your home.

Depending on the lender, you can typically cash out up to 80% of your equity. And because you’re getting a new mortgage, the process is generally the same as with any mortgage and you will need to pay closing costs.

How Can You Finance a Home Addition Without Equity?

If you haven’t built up a lot of equity in your home or would rather not tap into it, there are plenty of other ways to finance your home addition. 

Here are some of the most common:

Cash

If you have the cash to fund your addition out-of-pocket, this is the simplest way to pay. Just be sure you are not depleting your emergency savings or taking from another account you may need soon. 

It’s also important to consider interest rates and the return on your investment. Let’s say you’re investing your extra cash and earning more money than a loan would cost you in interest and fees. In this case, it just might be better to take out a lower-interest loan and continue investing your cash.

Credit card

Sometimes, people find it easy and convenient to fund a home addition using a credit card, or two. This can be a good idea if you have a credit card with an introductory interest rate lower than the rates on available loans. 

Note that you’ll need to pay off what you’ve charged to your credit card before the introductory period is over. Once the interest rate changes, the new rate could be steep, sometimes 20% or higher.

Be sure to make all your credit card payments on time and in full. Otherwise, your credit score can take a hit, and you could rack up late payment penalties as well.

Personal loan

An unsecured personal loan can be an option for people looking to finance their home addition. “Unsecured” means the loan isn’t backed by collateral. Because of this, a personal loan tends to have a higher interest rate than a home equity loan, but a lower interest rate than a credit card. 

Many times, what a lender might call a home improvement loan is just a personal loan used for home renovations. 

Personal loans are usually fixed-interest installment loans with a repayment term of 1 – 7 years. Qualifying will require a decent credit score (as defined by the lender) and a DTI up to 36%, though some lenders may consider a DTI as high as 50%.

What’s great about a personal loan is the quick turnaround time. You can get the money in as little as a week or two. 

FHA Title I loan

The federal government offers some loans, such as the FHA 203(k) loan, that are geared toward homebuyers looking to purchase a fixer-upper or home needing an addition. These loans combine the mortgage and home renovation loan into one loan.

But with the FHA Title I loan, the government lends money to existing homeowners looking to add on to their homes. 

The FHA Title I loan is backed by the government, but can be found at a private lender. It is geared toward helping homeowners finance just about any project that will improve their home. However, it can’t be used to finance luxury renovations like adding a swimming pool.

These loans are typically unsecured if the loan amount is under $7,500. For a single-family home, the maximum amount a homeowner can borrow is $25,000, and the maximum loan term is 20 years.^[1]

Get the Best ROI on Your Home’s Growth 

The best loan for you will depend on your financial circumstances. But regardless of the route you take, be sure to use reputable home improvement contractors and lenders, and go over your loan contract thoroughly. 

Consider consulting with a financial professional about how best to finance your project, and a real estate agent to ensure the best return on your investment.