Basement Financing: How to Pay for Finishing a Basement
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Whether you need basement financing to start or finish a home improvement project, you have various options to choose from, like a personal loan or home equity loan. To help you explore all your basement financing options, we cover the basics and pros and cons of each below.
5 ways to finance a basement remodel
Finishing a basement costs just over $18,000 on average, according to HomeAdvisor. Depending on the features and finishes you choose, the estimate to finish your basement could be more than that. Since most people don’t have that kind of cash lying around, it makes sense to explore basement financing options.
Although you may choose whichever funding option comes with the lowest fees, you should consider other factors, such as the repayment term, whether the loan is backed by collateral and how quickly you could get funding.
Here are five choices that could help you achieve your home improvement goals:
- Home equity line of credit (HELOC)
- Home equity loan
- FHA 203k loan
- Personal loan
- Contractor financing
Home equity line of credit (HELOC)
Like a home equity loan, a HELOC taps your home’s equity, which is the difference between the value of your home and what you still owe on your mortgage. You can usually borrow between 80% and 90% of your equity, and there may be a minimum as well.
HELOCs are commonly used for home improvement projects. As a line of credit, a HELOC allows you to make purchases on a rolling basis for a period of time known as a draw period. You can tap your line of credit until you reach your maximum or until the draw period ends. During the draw period, you’ll typically only be required to pay interest each month. You’ll then enter a repayment period, during which you’ll pay back the balance with a variable interest rate. There may also be a balloon payment due at the end of the loan.
Because your home is used as collateral, the primary drawback of this financial product is that you could lose your property if you fall behind on payments.
| Lower interest rates: As your home is used as collateral, you could see low interest rates.
Draw period: A HELOC lets you make payments on a rolling basis over a set period of time.
Tax-deductible: You may qualify for a tax deduction if you use your HELOC to improve your home with a basement remodel.
| Fluctuating interest rates: HELOCs are adjustable-rate mortgages (ARM), meaning your interest rate can rise or fall over time. Some lenders offer interest rate caps, however.
Risk of foreclosure: A HELOC is secured by your home. Defaulting on your debt could lead to foreclosure.
Home equity loan
When you take out a home equity loan to finish your basement, you get a lump sum of money, which you’ll have five to 15 years to repay. Like a HELOC, home equity loans allow you to borrow against the equity in your home, usually up to 85% of the equity you have. But when deciding between a home equity loan and HELOC, there are several key differences to consider.
Unlike with a HELOC, home equity loans have fixed interest rates, making your monthly payments predictable. However, interest rates are generally higher. Home equity loans are also paid out in a lump sum, while you draw from a HELOC on an as-needed basis like a credit card. That makes home equity loans better for large projects you’ll need to pay for upfront, but your monthly payments will also be higher at first because you’ll be paying back principal and interest.
| Fixed rates: Your interest rate won’t change over the life of the loan.
Long terms: You can typically take five to 15 years to pay back a home equity loan.
Tax-deductible: Home equity loan interest is typically tax-deductible when you use the loan to make meaningful improvements to your primary home.
| High closing costs: You could pay as much as 5% of the loan amount in fees.
Higher interest than an HELOC: Your interest rate will likely be higher than your first mortgage and higher than you could initially see with an HELOC.
Risk of foreclosure: If your circumstances change and you can’t make your payments, you risk losing your home.
FHA 203(k) loan
If you buy a fixer-upper, you can get money for the home and renovations through a single FHA 203(k) loan. Or, if you already have a mortgage, you can get a 203(k) loan for certain rehabilitation purposes, such as finishing your basement. These loans are backed by the Federal Housing Administration.
There are two types of 203(k) loans: A limited 203(k) loan, which can only be used for minor basement remodels with no structural changes, and a standard 203(k) loan for major renovations. With a standard 203(k) loan, you’ll work with a consultant who coordinates with you and the contractor to see the project to completion, including releasing the funds from the lender to the contractor. You’re required to choose and hire an approved consultant, and fees vary depending on the project. With a limited 203(k) loan, you’re not required to pay for a consultant, and the amount is capped at $35,000.
You can qualify for a 203(k) loan with fair credit, but you can’t have any foreclosures from the last three years. Keep in mind you’ll need to pay a down payment and mortgage insurance premiums, and you’ll be subject to a loan limit in your area. Depending on the median home value where you live, this could be anywhere from $356,362 to $822,375 in 2021. You’ll also need to use an FHA-approved lender.
| Lower interest rates: FHA 203(k) loans typically have lower interest rates than other types of loans.
More money available: An FHA 203(k) loan may allow you to borrow more money to cover your project than you would be able to with a private loan.
| Rigorous requirements: There are a number of requirements that must be met in order to take out an FHA 203(k) loan.
Lengthy application process: Expect the process to take much longer than other financing options like a personal loan.
Personal loans are fixed-rate loans that can be secured or unsecured. (A secured loan requires collateral.) You can typically borrow between $1,000 and $50,000 or more, depending on the lender. Repayment terms typically range from 12 to 60 months.
A major perk in using a personal loan is that funding can be fast, with some lenders issuing funds the same day you’re approved. Funds can be used for most purposes, as well, giving you the flexibility to spend as you see fit.
Good credit isn’t always required, but rates can be high on unsecured personal loans if your credit score is damaged. The average unsecured loan APR for someone with a score of 640 to 679 is over 24%. And borrowers with lower credit scores may not qualify without a cosigner. On the other hand, if you have excellent credit, you could qualify for a low-interest personal loan without added fees.
| Financing flexibility: If you need a few years to pay off your basement remodel, you could get a short-term personal loan. If you need longer, you could simply opt for a longer repayment term.
Fixed monthly payments: Since personal loans offer fixed monthly payments, you’ll know exactly how much you’ll owe every month.
No collateral required: Most personal loans are unsecured, so you don’t risk going into foreclosure if you default on the loan like you would with a home equity loan.
| Strict qualification requirements: Unsecured personal loans are backed only by your promise to repay the lender, so your eligibility and APR will be largely determined by your credit.
APRs can be high: Unsecured personal loans carry high APRs for subprime borrowers, especially when compared to secured loans. Plus, you can expect to start paying interest as soon as you take out the loan.
Origination fees: You may be required to pay origination fees of 1% to 8% or more, depending on the loan you select.
Most contractors offer financing options. They do so by working with a lender, so the terms and interest rates will vary. However, some may offer interest-free financing in the short term, such as 12 to 18 months.
Be sure to confirm whether such financing charges deferred interest, however. With deferred interest, you won’t be charged interest so long as you pay off your balance in full within the financing period; if you have a remaining balance, you’ll be charged interest from the original purchase date.
Don’t let the convenience of contractor-offered financing stop you from shopping for other financing options. Carefully weigh your costs. And strongly consider the reliability of the contractor as well as their labor fees before agreeing to use them.
| Convenience: Contractors can give you a better understanding of how much you can borrow or what you can accomplish for the cost.
Tailored to your project: Only borrow exactly what you need to get the job done.
Low or no interest: Depending on the contractor you work with, they may offer interest-free financing or low-interest traditional financing.
| Shorter terms: You may have some flexibility with the term, but you likely won’t have up to 15 years for repayment like you would with a home equity loan. Most interest-free offers are 12 to 18 months.
Fees baked into cost: Some contractors may build the cost of a project to include financing fees, which means you could end up paying more for the job.
Not always available: Choosing contractor financing means you’ll have fewer options with regards to which contractor to use.
Comparing your basement financing options
There’s a lot to keep track of when comparing your basement financing options, so you may want to make a spreadsheet or find another way to keep track of the total cost for each option. You’ll also want to compare lenders for each option so you can get the lowest APR and most favorable terms. Once you have a personalized cost estimate for each type of financing, you can compare the following.
APR: The APR, or annual percentage rate, is a great measure of your borrowing costs. It takes your interest rate plus other fees into account. A high APR can significantly increase the price of your basement remodel.
Term length: By paying off your basement remodel sooner, you can pay less in overall interest. However, if you feel you won’t be able to pay off your loan in a shorter period of time, opt for a financing option like a personal loan as it can offer a long term.
Loan fee: Take the time to understand the loan fees, such as closing costs on a home equity loan or HELOC. Loans and lines of credit with no or minimal fees are likely your best bet.
Monthly payment: Refrain from financing a basement remodel until you calculate your monthly payment and know it’s an amount you can comfortably afford.
Risk: Some loans for basement remodels are riskier than others. For instance, you may face counterparty risk with contractor financing. Counterparty risk relates to the fact that the contractor may or may not perform the job to the degree of satisfaction you originally expected and at the agreed-upon turnaround time. With a home equity loan, HELOC or FHA 203(k) loan, you could face foreclosure if you default on payments. If you want to reduce the risk of your loan, you may be better off with an unsecured personal loan or similarly unsecured product.
Is a basement remodel worth it?
While the cost to finish a basement is often steep, it’s a great way to increase your home value and can provide more space and more amenities for your family. HomeAdvisor estimates that you could potentially get up to a 75% return on your investment when you finish your basement. That means that if it costs $10,000 to finish your basement, you’ll add value to your home in an amount up to $17,500. Add to that the value your family will get out of that space while you’re still living in your home, and in most cases, you’ll find that it’s worth it to finish your basement.
That said, you should be in a financially stable situation any time you borrow money for an expense such as home improvement. If you’re deep in debt and barely making ends meet, the added strain on your budget from a monthly loan payment could be overwhelming. Focus on getting out of debt and building your emergency fund before you consider upgrading your home.