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Thinking of renovating or remodeling your home? You’re in good company. More people than ever are choosing to stay put, investing their time, money and effort into home improvements instead of selling.
But let’s face it, home improvements can cost thousands of dollars. Some of us may not have the finances to make that dream home makeover come true. So how do you pay for it?
To make the most of your investment in your home, it helps to have the best home improvement loan for your financial circumstances. Use this guide to get the insight and information you need on how home improvement loans work and what type of loan might be the best fit for you.
What Is a Home Improvement Loan?
A home improvement loan is any loan you take out to cover the costs of home repairs, upgrades, remodels, additions and other renovations.
There are a wide range of financing options out there, and each loan offers something different. Options include secured loans (those that require collateral) and unsecured loans (no collateral required) as well as secured and unsecured lines of credit. You can finance home improvements with a personal loan, home equity loan, government-secured loan or credit cards.
How Do Home Improvement Loans Work?
Here are some of the most common types of home improvement loans, how they work as well as pros and cons for each.
A personal loan is typically an unsecured installment loan, though some lenders may also offer a secured personal loan with a lower interest rate.
With a personal loan, you’ll get your loan funds as a lump sum, usually $2,000 – $50,000. You pay it back, plus interest, in monthly payments with a fixed rate over a set repayment term, typically 1 – 7 years.
An unsecured personal loan doesn’t require collateral. So there’s no risk of losing your property if you default.
You can get your funds quickly, usually within a week, and sometimes within 1 business day.
Some lenders charge fees, like origination fees or prepayment penalties.
Unsecured loans have higher interest rates than secured loans, especially if you have bad credit. For unsecured personal loans, the average rate is somewhere in the range of 8.8% – 9.9%
A cash-out refinance (or cash-out refi) replaces your current mortgage with a new one for more money than you owe. You get the extra money as a lump sum to use for whatever you’d like.
In general, you’ll need at least 30% equity in your home to qualify for a cash-out refi.
Because you’re replacing your existing mortgage, you’ll have one monthly payment.
Most lenders will let you borrow up to 80% – 90% of your home equity.
Home equity loan
With a home equity loan, you get your loan funds as a lump sum of up to 85% of your home’s equity. The borrower repays the loan, plus interest, in fixed installments over a set repayment term, usually 5 – 15 years.
Because a home equity loan is secured, the interest rate will be lower than for an unsecured loan. On average, home equity loan rates for a 5-year term tend to be 4.5% – 5.0%.
Home equity loans have fixed interest rates, and you borrow a lump sum of money. So your monthly payments are predictable.
You’ll typically need at least 20% equity in your home to qualify for a home equity loan.
Because you’re taking out an additional mortgage, you’ll have two monthly payments.
Home equity line of credit (HELOC)
Think of a HELOC as a sibling to a home equity loan. They’re both second mortgages that leverage your home’s equity. However, there are key differences between a HELOC and a home equity loan.
A HELOC typically has a variable interest rate, meaning it can fluctuate after an introductory period and any time the market rate changes. Instead of getting a lump sum, you get an amount of money you can borrow from, as you need, and only pay interest on what you borrow.
A HELOC has two periods. The first is a draw phase where you’re free to borrow against the line of credit, typically 10 – 15 years. When the draw period ends, a repayment period of up to about 20 years begins. This is when you pay back the loan.
Like a home equity loan, a HELOC is a secured loan. So you’ll have a lower interest rate than for unsecured loans, like personal loans or credit cards. Average HELOC rates are around 4.2% – 4.4%.
Because you can borrow a portion of the line of credit you get, you’ll only pay interest on what you actually use.
Like a home equity loan, you’ll usually need at least 20% home equity to be approved for a HELOC.
Because the interest rate is variable, there’s a chance it could rise with market rates.
Credit cards use revolving credit and have variable interest rates. They’re readily available to most of us, but interest rates tend to be high. Also, missing payments can rack up fees, increase your balance and negatively affect credit.
It’s easy to use a credit card to pay for home improvement purchases, just as you would for any purchase.
Sometimes, credit card companies offer an introductory rate at a very low, or even 0%, APR. If you can pay off what you borrow during this introductory period, it’s like borrowing money for free.
Depending on your home improvement project, your credit card may not have a limit high enough to fund it.
Even if you get a card with a low introductory rate, it can spike after the introductory period to 18% or higher.
The Federal Housing Administration (FHA) and United States Department of Agriculture (USDA) back loans earmarked for home improvement. They are available through approved banks, credit unions and online lenders.
The federal government also backs renovation mortgages to fund a fixer-upper home purchase.
FHA 203(k) refinance loan
There are two kinds of FHA 203(k) loans. The limited FHA 203(k) loan is for projects up to $35,000, while the standard FHA 203(k) loan is for projects that cost over $35,000. Both require you to borrow at least $5,000.
FHA title I property improvement loan
The FHA title 1 loan lets you borrow up to $7,500 in unsecured funds for a one-family primary residence.
FHA energy-efficient mortgage (EEM)
This is a loan specifically for energy efficiency improvements for homeowners with an FHA home mortgage.
USDA section 504 home repair
This loan is for repairs, improvements, upgrades or safety and health-related renovations in rural homes. The maximum loan is $20,000 for most areas and offers a 20-year term and 1% interest rate. Applicants must make no more than 50% of the area’s median income and live in an eligible rural area.
Government-backed home renovation loans typically don’t require a minimum home equity amount.
You may be able to qualify for a government-backed home improvement loan even if you have a low credit score.
Lenders need to be approved by the FHA or USDA, so it can be harder to find one.
Government-backed loans can take several weeks or months to get approved, which can delay the timeline of your project.
What Will I Need To Apply for a Home Improvement Loan?
Depending on the lender, qualifications for a home improvement loan will vary. But here’s what you should gather, and what you’ll typically need to qualify for a home improvement loan.
- Get a free credit report: Creditworthiness counts. Take this opportunity to get a free credit report online. You’ll be able to check your credit history – everything you’ve applied for, borrowed, paid back and may have defaulted on.
- Find out your credit score: To get a home improvement loan, you’ll generally need a credit score of at least 620, but exact credit requirements depend on the lender. You may be able to get a government-backed home improvement loan with a credit score as low as 500. It’s smart to check your score and get an idea of which loan you might qualify for. As suspected, excellent credit will likely get you lower interest rates.
- Calculate your debt-to-income (DTI) ratio: This calculation compares how much you owe to how much you make. Let our DTI calculator do the math for you. A general guideline is to keep your DTI below 36% to qualify for new credit, though some lenders (and government-backed loans) have looser standards. But the lower your DTI is, the greater your chances of qualifying and getting better loan terms are.
- Collect all income, financial account and personal information paperwork: Grab your latest pay stubs and a W-2 or two. You’ll also want your social security number, two forms of identification, tax returns and bank statements.
- Select a loan option from the lender: Look for the options that match your desired interest rate and the loan amount you need to pay for your home improvement project.
- Fill out loan applications with lenders of interest: Once you’ve picked your favorite lenders, there’s only one thing left to do: apply! The application process is different for each lender. Some lenders will let you apply online or over the phone. Others will want you to come to a branch in person.
- Get ready to renovate!
Put Down the Saw: Pick The Right Loan For the Job
Getting the home upgrades you want requires some lender comparison shopping as well as deciding which home improvement loan best suits your decor dreams and budget.
Take your time. Research all of your options. Get the right loan and the lowest rate. And maybe pick that saw back up – or get a contractor to do the work for you!
Ready to make a change?
Whether you want to buy a house, refinance or take cash out, you’re not alone. The experts are just a click away.
National Credit Union Administration. “Credit Union and Bank Rates 2022 Q2.” Retrieved July 2022 from https://www.ncua.gov/analysis/cuso-economic-data/credit-union-bank-rates/credit-union-and-bank-rates-2022-q2