- Home improvement loans can be a great way to finance a home renovation project if you don’t have enough money in savings.
- Consider the tangible value your home improvement project adds to your home, in the event you consider selling.
- There are both secured and unsecured home improvement loans, from home equity lines of credit to personal loans, and it’s important to do your research to figure out which one is best for you.
Maybe you’re sick and tired of your 1980s-era cabinets and you want to remodel them. Perhaps you want to install a more colorful backsplash in your kitchen. Or maybe you’re finally ready to tackle your unfinished basement once and for all.
There’s just one problem: You don’t have enough money in savings to cover the cost of your home improvement project. But don’t worry just yet. There’s something called a home improvement loan that can help you finance your project.
The term “home improvement loan” doesn’t refer to a specific loan type, but rather is used as an overarching, umbrella term to describe a loan that’s used for a home improvement project. The source of the loan can either be secured — such as a home equity loan (HEL), home equity line of credit (HELOC), or cash-out refinance — or it can be unsecured, such as a personal loan or credit card. Unlike a construction loan in which a lender releases funds to you as your house is being built, you will manage the loan proceeds to fund your project. This means it’s crucial to plan and budget for your expenses carefully.
Read on for a step-by-step guide to everything you should know about home improvement loans.
Step 1: Consider Your Project
Before you even think about taking out a loan to cover home improvement costs, consider whether this is a wise investment in the first place. Will this project be a worthwhile expense that will increase the value of your home? Or is it just a fun project that will cost a lot but won’t bring significant added value to your house?
According to research from Consumer Reports, modern, updated kitchens (think stainless steel appliances and quartz countertops) can bump up a home’s sale price by 3% to 7%. In addition, open layouts, finished basements, and “flex rooms” can boost a home’s price by 4% to 6%.
On the other hand, things you might think add value, such as pools and upscale landscaping, don’t actually add much value to a home. Before taking out home improvement loans, consider whether the project in question will add some resale value to your home, instead of just providing enjoyment for your family. Your priorities might change when you think of your different options.
Step 2: Learn About the Different Types of Home Improvement Loans
If you’ve decided you’d like to take out a home improvement loan, the next step is to research your options. Below, we’ve broken down the two types of loans — secured and unsecured — with a look at the various options in each category.
Typically speaking, secured home improvement loans are a better loan type than unsecured loans. Because secured loans are backed by collateral, such as your home, they often come with more favorable loan terms, such as lower interest rates and fixed monthly payments.
Home Equity Loan
Also referred to as a second mortgage, a home equity loan (HEL) is a loan that is secured by the equity you hold in your home. In short, your home is used as collateral.
One benefit of HELs is that your monthly loan payments will be fixed — many people like this sense of predictability. Loan terms on HELs are also long (typically between five and 15 years), which is ideal if you’d like some flexibility in repaying your loan. HEL interest rates vary and depend on your credit score, but average interest rates for 10-year HELs right now fall between 6% and 11%. Unlike a HELOC (covered below), HEL rates are usually fixed and have required monthly payments that ensures you are paying down your loan balance.
The main downside to HELs is that your home is used as collateral. This means that in the event that you cannot repay the loan, you risk losing the roof over your head. Also, keep in mind that while HELs often come with favorable interest rates and terms, you will likely have to pay closing costs and fees.
Shop around before selecting a HEL, and keep in mind that some lenders will require a minimum credit score, such as 620.
Home Equity Line of Credit
Similar to HELs, home equity lines of credit (HELOCs) are a revolving line of credit in which your home is used as collateral. Consider a HELOC over a HEL if you’re undertaking a project with costs that start off small, because you only pay interest on the amounts as you draw money from your HELOC, not the full amount available to you.
With a HELOC, you borrow money as you need it and repay amounts when you’re able, much like you would with a credit card. With HELs, interest rates are fixed. With HELOCs, however, they can either be fixed or variable, meaning your interest rate could change because the variable rate fluctuates with the interest rates set by the U.S. Federal Reserve. In a rising rate environment, be aware that your cost of borrowing might increase, sometimes significantly. HELOCs typically come with borrowing terms (the time in which you can withdraw funds) of up to 10 years and repayment terms of up to 20 years, and may also come with an annual fee.
Similar to a HEL, a HELOC is backed by collateral: your home. Consider a HELOC if you are certain you will be able to repay the funds you draw, even if the repayment is not defined or scheduled unlike with a home equity loan.
Another type of secured loan worth considering is a cash-out refinance. This involves taking out a new mortgage for more money, leaving you with the difference to spend on your home improvement project. With a cash-out refinance, you can typically only take out an amount that’s 80% to 90% of the equity you hold in your home, which means this option is only worth considering if you hold significant equity in your home.
Cash-out refinances typically come with lower interest rates than HELs and HELOCs, because they are essentially first mortgages, which makes them a worthwhile option to consider. However, keep in mind that similar to HELs and HELOCs, you will have to pay closing costs and other fees, plus you’re putting your home up as collateral, meaning you risk losing it if you fall behind on your payments.
Interest paid on HELs and HELOCs can be deducted come tax season, but keep in mind that there are more restrictions than there used to be. Interest on cash-out refinances, a first mortgage, is limited to the cost of buying, building, or substantially improving your home (called “acquisition debt”) and only up to certain limits. Remember to keep all of your receipts and to alert your tax adviser regarding your loan.
Unsecured home imrpovement loans are those that aren’t backed by a form of collateral. Typically speaking, unsecured loans come with less-favorable terms than secured loans because of this. However, if you don’t hold enough equity in your home or you’re worried about putting your home up as collateral, you can consider an unsecured loan.
Personal loans can be acquired from banks, credit unions, online lenders (such as LightStream and SunTrust Bank), and peer-to-peer lenders (such as Upstart and Peerform), and typically come in loan amounts that range from $1,000 to $50,000. Loan terms vary, but can be anywhere from one year to five years, or longer. Personal loan interest rates continually change, but typically fall somewhere between 6% and 36%.
The most important thing to keep in mind when considering personal loans is your credit score, as personal loan rates are closely tied to your credit score. You can typically only qualify for a low interest rate if your credit is in excellent shape. If it’s not, you run the risk of getting a rate that’s upwards of 20% or even 30%.
The main benefit of selecting a personal loan over a secured loan, such as a HEL or HELOC, is that your home isn’t used as collateral. In the event that you cannot repay the loan, you don’t risk losing your home. However, personal loans come with their downsides, including higher interest rates, shorter loan terms, and potential fees (i.e. origination fees) and prepayment penalties. Also, keep in mind that interest paid on personal loans is not tax deductible.
In the event that you’re only spending a few thousand dollars on a home improvement project (say a new kitchen backsplash or updated tile in your bathroom), you could consider using a credit card to pay for your expenses.
A credit card with a 0% introductory APR may be a wise choice but only if you pay off your balance within that time frame. (If you don’t, you run the risk of being forced to pay retroactive interest). With a 0% introductory APR credit card, you could be able to pay for your entire project interest-free.
Step 3: Prepare Your Credit
Regardless of whether you’re taking out a secured or unsecured loan for your home renovation project, your credit score and credit history will both come into play. After all, these two measures are the best way for a potential lender to assess your creditworthiness as a borrower.
If your credit isn’t in great shape, try to make improvements to your credit scores before taking out home improvement loans. This involves paying your bills in full and on time each month and watching your credit utilization ratio (the amount of available credit you use). Preferably you are paying down your debt elsewhere, too. Also avoid closing any credit cards to retain your credit history, and dispute any errors you find on your credit report.
By taking these steps to prepare your credit and increase your credit score, you’ll be able to qualify for a loan with a better interest rate and better terms, and get going on that home improvement project.