Updated Dec 7, 2022
A home improvement project may be the perfect solution if you want to enhance your home and increase its value. Despite these major benefits, home projects are pricey – sometimes costing tens of thousands of dollars.
A savings account is the most advisable way to pay for home improvements. This money is completely yours, and you won’t owe back large chunks of cash to a lender. However, you might not have enough savings to cover major home renovations – or you don’t want to drain your bank account in case of other life emergencies.
Luckily, you can update your home even if you don’t have the extra cash. Many homeowners use home improvement loans for financial support on major projects.
A home improvement loan is any form of financing a homeowner uses to pay for remodeling and renovation projects. There isn’t a specific type of loan designated for home improvement projects, but there are common financing options to get the job done. Home improvement loans come in the form of unsecured personal loans or secured home equity-based loans, depending on the type you qualify for.
The following sections will explain four types of home renovation loans. Each financing option has its advantages and disadvantages, along with different tiers of qualifying borrowers. While reading, consider which is the best fit for your financial situation.
Home equity loans are secured loans, which means you’ll use your home equity as collateral. Your home’s equity is the percentage of the mortgage you’ve paid off. If you’ve paid $150,000 of your $300,000 mortgage, your home equity is 50%. As you pay off your mortgage, you’ll develop more equity.
When you apply for a home equity loan, your lender will assess your loan-to-value ratio when determining your qualification. Loan-to-value ratio (LTV) compares your mortgage with the appraised value of your home. Lenders generally approve a maximum LTV of 80%, meaning you must own 20% of your home after funding. The loan-to-value ratio lowers as you gain more home equity, making you more likely to receive better loan terms and interest rates.
The lender will also consider your credit score, debt-to-income ratio, and proof of payment ability. You’ll likely need a debt-to-income ratio below 43% to qualify for a home equity loan, so assess your income and other monthly payments before applying.
If you qualify, you’ll receive the loan in one lump sum and repay it as fixed monthly installments. Since your home equity serves as collateral in the transaction, you’ll pay lower interest rates than you would on an unsecured loan. Better yet, your payments might be tax deductible.
So, there are some major pros to home equity loans. But, along with the benefits come some disadvantages.
The most obvious con of this loan type is that you must have home equity to borrow. If you just started making payments on your home, you likely won’t have enough equity to qualify. Even if you have sufficient equity, you might still have to pay for inspections and appraisals throughout the application process. These extra fees may be worth it if you qualify for a sizable loan. Otherwise, you’ll be out several thousand dollars you could’ve just put toward your home improvement project.
A home equity line of credit (HELOC) is a loan that allows you to borrow through a revolving credit line based on your home equity. The lender will approve you for a certain amount of credit for a specific time frame. During this period, you can borrow from and repay the balance up to your loan amount. When you pay outstanding balances, the credit will be replenished like it would in a credit card account.
Your lender will likely require you to have at least 15% equity in your home to qualify for a HELOC. Other lenders may also order a new appraisal on your home to determine the loan-to-value ratio. They’ll get this ratio by adding the amount you owe on your mortgage and the proposed line of credit to assess your total debt. Most institutions will only loan up to 85% of this value.
Here’s an example adapted from the Federal Reserve Board’s guide to HELOCs:
Suppose your home’s appraised value is $300,000. Your lender’s credit limit for home equity lines is 70%. They’ll take this percentage of the home’s appraised value – for example, $210,000 – and then subtract your existing mortgage balance from that number.
If you’ve paid $100,000 off of your mortgage, the calculation would look like this:
|$300,000 (home’s appraised value) x 70% (lender’s credit limit) = $210,000 (percentage of the appraised value) |
$210,000 (percentage of appraised value) – $100,000 (amount paid off of mortgage) = $110,000 (your potential line of credit)
An important factor to note about HELOCs is that they usually have variable interest rates. This means the interest you pay on your owed balance may fluctuate depending on the market. However, home equity credit lines typically have lower interest rates from the start, so you might not see a huge difference in the amount you’d pay with a fixed interest rate.
Personal loans are unsecured loans from banks, credit unions, and other lending institutions. These loans are “unsecured” because they don’t require you to use your home as collateral. They’re a more feasible option if you don’t have enough equity or want to avoid using your home as collateral. Instead, the lender will assess your credit score and charge high interest rates to ensure you’re a trustworthy borrower.
Once the lender approves your loan application, you’ll likely get the funding within a few days. A major benefit of personal loans is that you don’t need a certain amount of equity in your home to qualify. This means you can apply for an unsecured loan even if you just started paying off your house. Additionally, a wide range of institutions offer personal loans, making them an accessible loan option for many homeowners.
Personal loans may seem straightforward enough, but there are still some downsides to this financing option.
First, the loan amount will be lower than other financing options. Fort Bragg Federal Credit Union offers up to $25,000 for home improvement loans. Other institutions will lend more depending on your creditworthiness.
Also, consider that a personal loan will arrive at once as a lump sum and likely have a short repayment period. This factor is a disadvantage for homeowners completing DIY renovations with lengthy project timelines.
Cash-out refinancing allows you to take advantage of your home equity and the value your home has gained over time. A cash-out refinance effectively takes out a new mortgage to pay off your original one, allowing you to pocket the difference between the two. You can then use that amount for large expenses like home renovation projects.
Suppose you bought your home for $300,000, and the appraisal confirms this value. You can put down $60,000 as a down payment, so you now owe the bank the remaining $240,000.
Five years down the road, you decide to make some home improvements. You don’t have the savings to complete the project, so you opt for a cash-out refinance.
Five years go by, and you’ve paid your original mortgage loan down from $240,000 to $200,000. You apply for a cash-out refinance, so the bank orders a new home appraisal, which comes back at $400,000. In this case, the bank will issue you a second mortgage loan, up to 80% of $400,000 instead of the home’s original value of $300,000. You agree to take out a new mortgage with these rates, bringing your new loan to $320,000.
You use your new $320,000 to pay off the $200,000 remaining on your old mortgage. You now have $120,000 leftover to put toward your home improvement project.
While this process may seem like a straightforward path to funding, there are several things to consider before pursuing a cash-out refinance.
First, you’ll basically be starting from scratch with your mortgage – this time with higher monthly rates. If your home loan is higher, you’ll have to pay more for a longer period to pay it off. In the same vein, you’ll have to pay the appraisal fees, origination fees, and closing costs, which will likely cost thousands of dollars. If your cash-out was significant, the closing costs might be worth it. Otherwise, you might pay excessively for a measly sum and a higher mortgage.
As with a home equity loan, the bank will use your home as collateral for the loan. Before applying for either of these loan types, ensure you can afford the new payments. Otherwise, you’ll face outrageous interest charges and, ultimately, foreclosure.
To compare loan types and perform personalized calculations, visit MortgageCalculator.org.
Now that you understand the different types of home improvement loans, you’re ready to determine which is the best fit for your lifestyle and financial situation.
Home equity-based loans are great options for people who own a good percentage of their homes. Personal loans might be a better option for people without home equity or those unable to offer up their homes as collateral. Lastly, cash-out refinancing could be a solution for homeowners looking to take advantage of their increased home values.
No matter which loan you choose, assess your financial health and the loan terms thoroughly before signing any contracts. With the right financing option and a solid repayment plan, you’ll have the cash you need to transform your house into a home.
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