Construction loan vs. HELOC and how to choose

The choice of construction loan vs. HELOC for a new project relies on two main factors: the type of project and whether you already have equity in a home you own.

A ground-up build or major construction project generally calls for a construction loan. On the other hand, if you’re renovating your existing home you could fund it with your existing equity. 

Here’s how the two options work and what to consider before you choose one for your next project.

How do construction loans work?

A construction loan is designed to help finance the building or major renovation of a home. Rather than receiving the entire loan amount at once, borrowers typically receive funds in draws as the project reaches specified stages.

Construction loans could take several forms, depending on the lender and project:

• Construction-to-permanent loans that fund the initial build then transition into a traditional home mortgage after construction.

• Stand-alone or construction-only loans that fund the initial build but must be paid off or refinanced when construction ends.

• Owner-builder construction loans for homeowners with prior construction experience who will be doing some of the work themselves. 

How do construction loans work in practice? The lender and borrower agree on a construction budget and schedule, and the lender releases funds as the project progresses according to the loan’s terms.

What is a HELOC?

A HELOC is a revolving line of credit secured by your home. During the draw period, you can borrow, repay, and borrow again up to your credit limit repeatedly. Draw periods typically last five to 10 years, and then are usually followed by a 10 to 20 year repayment period where you can't borrow more and focus on paying off the loan.

Since the HELOC is backed by your home, it's tied to that property. If you sell the home, you need to pay off the HELOC for the sale to close. Even if you use the HELOC to fund new construction on another property, the HELOC is still tied to your home, not the new property.

As you compare a HELOC vs. a construction loan, consider your plans for your existing property. Are you building a new home and moving, or is it a secondary or vacation property? If you're doing a major rehab, do you plan to live in the home afterwards or sell it? These answers could help you choose the right path.

Construction loan vs. HELOC: Key differences

A side-by-side comparison could help you identify which type of financing fits your project best:

The biggest practical difference is whether you already have a property or not. You don’t need a completed property to get a construction loan; that’s the problem they’re designed to solve. A HELOC, however, requires you to already have property with sufficient equity you can borrow against. If you don't own a home, or that home doesn't have enough equity, a HELOC is off the table from the get-go.

Which type of funding should you choose?

The biggest thing impacting your decision is this: Do you already have a property? And if so, do you have enough available equity to borrow against it? If not, a HELOC isn't an option for you. But if you do, you could choose a HELOC or a construction loan, and the choice comes down to the nature of the project. 

To figure out if you have enough equity, lenders look at your combined loan-to-value (CLTV) ratio, which is all the debt against your home divided by your home's current market value. Most lenders cap CLTV at 80% to 90%. In other words, your potential loan amount is limited by the value of your current home—which isn’t necessarily the cost of your new build or renovation project.

So, start with the project scope and estimated financing needs. A ground-up build or major structural project could be better suited to a construction loan because, if approved, you can potentially fund the entire project with the one loan. 

A smaller build or renovation could be a better fit for a HELOC, which allows flexible borrowing during the draw period. This structure could also be helpful for phased remodels, where you complete a project, pay off the HELOC, then attack another project while still in the HELOC draw period.

Other ways to finance a home addition or renovation

Financing for a home addition or larger renovation could take several forms: 

• A home equity loan provides a one-time loan based on your available equity. 

• A cash-out refinance replaces your existing mortgage with a new, larger loan and gives you the difference in cash. It also requires home equity. 

• An FHA 203(k) could finance eligible rehabilitation work on an existing home, or a new fixer-upper that you’re buying.

• An unsecured personal loan could provide financing without using your home as collateral.

The right option for how to finance a home addition generally depends on your goals, as well as your home’s equity, the size of the project, your financial profile, and the terms you could get.

Explore a fixed-rate HELOC from Achieve Loans

While Achieve Loans doesn't offer construction loans, if you want to fund your home project with your existing home equity, afixed-rate HELOC could be an option. A fixed-rate HELOC could give you the flexible funding you need, without the stress of a variable rate that changes with the market. 

Find out if you’re eligible with no impact on your credit scores.