Since adding a new roof or doing extensive renovations is expensive, many homeowners that can’t pay their contractor in cash or have little equity built up in their homes finance their renovation projects with home improvement loans instead of using their credit cards.
Other borrowing options include home equity loans or a home equity line of credit (HELOC), which are better options for homeowners that have sizable equity in their homes that they can borrow against.
Home improvement loans are useful for financing:
- Kitchen remodels
- Bathroom updates
- New deck/patio/porch
- New exteriors
- Green homes
- Home repairs
What is a home improvement loan?
Home improvement loans are personal loans used to fund home repairs and renovations. Home repair loans are unsecured loans you can obtain based on your creditworthiness from a variety of lenders, including a bank, credit union or online lender.
Since unsecured loans don’t require collateral, such as your home, you can obtain them at any time. These loans do not factor in the amount of equity you have in the house, townhome or condo. Home equity is the difference between the appraised value of your house and what you owe on your mortgage.
Home improvement loans can be an attractive choice for:
- Borrowers with good to excellent credit
- Borrowers who have recently purchased a home
- Borrowers looking to sell a home and need to spruce it up
- Borrowers who want to lease their home out to renters
Getting approval for a a home improvement loan can be done quickly compared to a home equity loan or HELOC. Borrowers often will receive their entire loan within a few days to a week.
The lender will give you a lump sum, such as $25,000, which helps you start a project quickly, especially if you need to purchase equipment or supplies or make a down payment to a contractor, plumber or electrician.
Another benefit is that your monthly payments will be determined in advance so that you can budget for this additional expense.
How do home improvement loans differ from home equity loans or HELOCs?
Here’s a brief list of what makes home improvement loans different:
- They’re unsecured: Unlike home equity loans and HELOCs, there is no need to use your home as collateral. Instead, lenders rely on your credit score to determine creditworthiness and what interest rate they will charge you for the loan.
- They have shorter repayment periods: Home improvement loans are generally repaid over two to seven years, depending on the lender. In contrast, home equity loans and HELOCs have repayment options of up to 20 years.
- There’s more freedom involved: The loan amount is not limited by the amount of available equity you have in your home. You can also use as little or as much of the money as you need, especially if your project is extensive and will last more than a few months.
- They have fixed rates: Home improvement loans have fixed interest rates. That means your monthly payments will remain the same from month to month for the life of the loan. Borrowers can budget for their dream home without worrying about rising monthly costs.
- The could potentially lower closing costs: The origination fees vary depending on the borrower’s credit score, instead of a fixed 2 percent to 5 percent of the amount of a home equity loan.
When are home equity loans or HELOCs the better option?
Home equity loans are a better option for individuals who have lived in their home for several years, paid a 20 percent down payment and have built up a sizable amount of equity. Many homeowners prefer home equity loans because they offer lower, affordable interest rates due to the fact that the lender has less risk because the borrower has pledged the home as collateral.
HELOCs give borrowers the benefit of an extended draw period, or time frame in which they can tap the line of credit for cash. The average is 10 years, which means you can borrow money as you need it up to a certain limit for repairs or renovations. During the draw period, borrowers typically can make interest-only payments each month if they want. Borrowers can borrow as much or as little as they need similar to a credit card. For homeowners facing a variety of improvement projects with different costs and lengths, ranging from adding a new stove to adding a new room, a flexible HELOC might work best.
Most HELOCs come with a variable interest rate (often referred to as “floating rates”), which means the amount of money you pay back each month can increase or decrease. The amount of interest you pay is determined by a number of factors, including interest rate levels set by the Federal Reserve, investor demand for Treasury notes and bonds and the price movement of benchmark rates used by the banking industry. Each factor can affect your interest rate.
How to use a home improvement loan to increase value
Since not all home improvement projects are created equal, some will cost more while adding little to your property’s value. Comparing the cost of the project to its value can help you determine the return when it comes time to sell.
The projects that recoup most of the costs, according to the Remodeling 2019 Cost vs. Value Report include the following:
- Garage door replacements (97.5 percent cost recouped)
- New manufactured stone veneers (94.9 cost recouped)
- Minor kitchen remodel (80.5 percent cost recouped)
You want to be sure you’re getting the most bang for your buck with any home improvement. Just because you want to add a gazebo or hot tub doesn’t mean the next buyer will be a fan.
What you’ll need when applying for a home improvement loan
Shopping around will help you find the most competitive rate possible. Once you determine your timeline, type of project and cost, it is time to apply for a loan.
Here’s what you’ll need to have ready before applying for a home improvement loan:
- Your credit score: The most favorable rates often go to borrowers with the highest credit score. Every lender you apply with will ask for your credit score and credit history.
- The cost of your project: Home improvement projects can vary widely in cost. Remodeling your powder room won’t cost the same as replacing all the windows in your home. Before applying, know the cost of your materials and length of your project. Don’t borrow more money than you need.
- Your debt-to-income ratio: You can calculate your debt-to-income ratio by dividing all of your monthly debt payments by your monthly income. On average, home improvement lenders consider a 20 percent debt-to-income ratio low. Many lenders will consider borrowers with higher ratios, but the cutoff is around 50 percent.
- Your personal information: This includes information such as your Social Security number, employment history, income, employer information and a list of any monthly debts, such as a car loan, student loans and credit card payments.