How Does a Remodeling Loan Work?

When you first apply for a remodeling loan, you submit a budget, plans and specs to the lender. You also develop a draw schedule. This schedule tells the lender approximately how often and how much you will draw from the line. Unlike home equity lines of credit, draws on a remodeling loan are non-revolving. This means that even if you pay down principal before the loan converts, you will not have those funds available again. When you need to make a draw, you submit invoices and an inspection report to the lender to show the progress being made. If satisfied that the project is on track, the lender will advance the money per the draw schedule.

During the draw period, the loan will carry a floating rate based on an index plus a margin. The index is the base rate, typically Prime as published in the Wall Street Journal. The margin is the percentage above or below the base rate. If your loan is priced at Prime plus 1 percent with Prime being 3.25 percent, the net rate is 4.25 percent. The term floating rate means that the rate changes along with the index. This means if your rate is Prime plus 1 percent and prime goes down to 3 percent, your new net rate is 4 percent. The rate goes into effect the same day the base rate changes and stays there until it changes again.

The draw period is based on the time you estimate for completion when drawing up your budget. Typical remodeling loan draw periods are 6 to 12 months. Often, your lender will insert an automatic extension clause into the promissory note to account for unexpected delays. These automatic extensions are typically between 3 and 6 months. The draw period is over on the earlier of the project completion or the expiration date as detailed in the note.

After the draw period ends, the loan will convert to permanent financing. The funds that have been advanced for the remodeling will essentially become a conventional amortizing mortgage. During the draw period, you will pay interest only monthly on the funds that you've advanced. When the loan flips to permanent, you will pay equal installments of principal and interest sufficient to pay down the loan over the agreed upon term. Your rate will change from floating to fixed once the loan converts to permanent financing.