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Thursday, January 16, 2025

Comparing Home Equity and Improvement Loans: Which is Right for You?

Upgrading your home can feel like both a dream and a dilemma. It’s not just picking out the right flooring or the best paint color–it’s also how to fund those home renovations. With a world of financing options available, understanding the right choice can save you time, money, and a lot of stress.

Home equity loans and home improvement loans are two popular paths homeowners consider for funding their home upgrades. Each has its own perks and loan requirements. Deciding to tap into your home’s equity or to secure a different loan can significantly impact your finances and renovation journey.

Delve into the ins and outs of home equity and improvement loans. Identify which financing option best suits your needs, and explore ways to invest in your home and your future.

A person wearing a blue cap and shirt, along with white gloves, is installing a wooden sliding door. They are using a tool to adjust the door mechanism. A teal geometric design with "ez" is on the left side of the image.

What is a home improvement loan?

A home improvement loan is a type of personal loan specifically designed to help homeowners finance renovations, repairs, and upgrades. Unlike home equity loans, these are usually unsecured, meaning you don’t have to put up your home as collateral. So, this might be the perfect loan option if you want to upgrade your kitchen or replace that aging roof.

Loan Details:

Table displaying loan features: Loan amounts range from $1,000 to over $100,000. Interest rates are typically fixed. Monthly payments are fixed with structured repayment plans. No collateral required for these unsecured loans.

Home improvement loans are great for a wide range of projects, from energy-efficiency enhancements to bathroom makeovers. Their fixed interest rates and monthly payments make budgeting easier, as you know exactly what you owe each month.

Common Improvement Projects:

  • Roof replacements
  • Kitchen upgrades
  • Bathroom renovations
  • Energy-efficiency improvements

With several loan options available, you can tackle any project without draining your savings. It’s a simple, hassle-free way to turn your house into the home of your dreams!

Qualifying for a home improvement loan

The application process for these personal loans can be simpler, especially if you have an excellent credit score. Every lender will have different eligibility requirements, but generally, you’ll want 670 and above to qualify and get better loan rates. Bad credit scores may still be approved for a personal loan but at higher interest rates.

The lender will also want proof of income, as this is an unsecured loan. They check whether the borrower has the household income to repay the loan. They’ll also use this information to evaluate your debt-to-income ratio.

The loan amount is a factor in the approval process. But, without the need for a home appraisal, you can have funds faster and start work within days, not weeks or months.

Home improvement loan terms

Each financial institution will have different loan programs. Generally, the repayment terms on a personal loan are shorter, about one to five years. It’s worth shopping around with credit unions, banks, and other lending institutions.

However, remember that interest rates can be higher, especially if you have bad credit, so it’s crucial to compare different loan options and their Annual Percentage Rates (APR) before making a decision. Remember to ask about origination fees or other lender fees.

Benefits of a home improvement loan

The loan approval process is surprisingly quick, but that’s because this is a personal loan. You can access the funds usually within a week, but sometimes as fast as the next business day. The amount you can be approved for also varies widely. You’ll get a single lump-sum payment to use for your remodel project.

Downsides to a home improvement loan

For starters, the repayment schedule is less generous. Usually it falls somewhere between one and seven years to pay back the loan.

Loan approval also hinges on your whole credit profile. Those with high debt-to-income ratios and poor credit scores may not qualify or have to pay higher interest rates. What you can be approved for depends more on your income and assets.

The interest you pay on the home improvement loan isn’t tax deductible, either.

What is a home equity loan?

Home equity loans are an option if you’ve built up significant equity in your home. These second mortgages require you to use your home as collateral, making them a secured loan. They potentially offer larger loan amounts with lower interest rates than personal loans.

You generally need a good credit score, adequate equity, and a stable income to qualify. Repayment periods span from 5 to 30 years, offering flexibility and manageable monthly payments.

Benefits of Home Equity Loans:

A table listing benefits of home equity loans with details: higher loan amounts, lower interest rates, longer repayment terms, potential tax benefits, and versatile use of funds. Background shows people standing with painting equipment.

The loan funds can pay for your remodeling project, but you can also save some of the funds for things like debt consolidations, paying medical expenses, or funding a kid’s college education. The lender gives you a lump sum payment that you can use as you wish.

Downsides to home equity loan

It’s not all fresh paint and new kitchens with this second mortgage, though. Most mortgage lenders cap how much equity you can borrow. Those who own the home outright usually are limited to 85% of the home’s appraised value. But if you only owe 50% of your home, you can’t borrow more than you own outright.

You’re also taking what you owe–an asset–and converting it into debt. That impacts your monthly spending, as you’ll owe a new bill, have a higher debt-to-income ratio, and qualify for fewer lines of credit or lower amounts.

The approval process takes longer as the financial institution will want a current home appraisal to verify the home’s value. You’ll also pay closing costs, as the bank considers it a second mortgage. Be prepared for an additional 2-5% just for the pleasure of having access to funds.

You’ll also keep making payments on the primary mortgage’s outstanding balance. Defaulting on your original loan or the second mortgage places the home at risk of foreclosure.

Should you choose a home equity loan or a home improvement loan?

When financing your dream renovation projects, deciding between a home equity loan and a home improvement loan can be tricky. Both options have pros and cons, but choosing the right one depends on your financial situation and improvement goals. Consult a trusted financial advisor to make an informed decision.

When should I get a home equity loan?

A home equity loan can be a solid choice if you’ve built up a significant amount of equity in your home. Typically, lenders prefer you to have at least 15-20% equity, but more is better.

This loan lets you borrow often at competitive rates, which can be helpful for substantial home improvement projects, like adding a new room or remodeling the kitchen. Keep in mind, though, that this type of loan uses your home as collateral, adding some risk if you can’t keep up with monthly payments.

When should I get a home improvement loan?

A home improvement loan might be better if your equity is limited or you prefer an unsecured loan. These personal loans are handy for smaller projects or quick access to cash. The application process for these loans can be simpler, especially if you have a good credit score.

However, remember that personal home improvement loans have higher rates and shorter repayment terms, especially if you have bad credit. Those with a strong credit history stand the best chance of getting the lowest interest rates. Compare the Annual Percentage Rates (APR) and other loan terms before making a decision.

Here’s a quick comparison to help you decide:

Comparison chart of a home equity loan and a home improvement loan. It contrasts loan type, uses, equity requirement, interest rates, risk, typical loan terms, and tax deductions. Background shows a person in construction attire in a partially renovated room.

Ultimately, the best choice depends on your credit history, income ratio, and the approximate cost of the home improvement project. Those still paying off a current mortgage with more debt than equity may prefer a personal loan. But those with a big budget project in mind might find home equity to be the choice for improvement projects.

FAQs

Are there other home improvement financing options?

Are there other home improvement financing options?

Yes, there are several alternative financing options to consider when looking to fund your home improvement projects:

  1. Home Equity Line of Credit (HELOC): A HELOC allows you to borrow against your home’s equity with a revolving credit line. During the draw period, you take funds from this line of credit as needed, which can be advantageous for phased or ongoing projects. Interest rates are typically lower than personal loans, and you only pay interest on the amount you borrow. However, remember that like a home equity loan, a HELOC is secured by your home. It can also come with variable interest rates, complicating budgeting for payments. It does have tax advantages if used for home renovations.
  2. Federal Housing Administration (FHA) 203(k) Loans: These loans are designed for those looking to purchase a home that requires renovations or upgrades. The FHA 203(k) program allows you to finance both a house purchase and the costs of repairs in a single mortgage. This option is beneficial for buyers looking for fixer-uppers and can mean an opportunity to increase the value of the home significantly. It is a fixed-rate loan, has application fees, and longer payback periods.
  3. Credit Cards: If your improvement costs are manageable and can be paid off quickly, using a credit card may be an option. Many credit cards offer promotional 0% interest rates for an introductory period on new purchases. Just beware: the average rates on credit cards are hovering about 20%, making them very expensive if you don’t pay them off quickly. Your borrowing limit is as high as your credit limit, and you’re increasing your credit card debt. That can be risky and negatively impact your credit score.

What disqualifies you from getting a home equity loan?

While home equity loans can be a great resource for funding renovation projects, not everyone may qualify. Several factors can disqualify you from obtaining a home equity loan:

  1. Insufficient Equity: Lenders typically require homeowners to have at least 15%-20% equity in their home. If current market conditions have affected your home value or if you have a high combined loan-to-value ratio (CLTV), you may not have enough tappable equity to secure a loan.
  2. Credit Score: Your credit report plays a significant role in the approval process. Most lenders prefer a credit score of 620 or above. A lower score may indicate risky repayment behavior, making lenders hesitant to extend credit. They also want to see an on-time payment history.
  3. Debt-to-Income Ratio (DTI): Lenders assess your DTI to determine your loan repayment ability. A DTI ratio above 43% is often viewed unfavorably. High debt loads relative to your income signal financial strain and may disqualify you from receiving additional financing.
  4. Employment History: Consistent employment history can impact your application favorably. Lenders want to see stable income sources, so frequent job changes or gaps in employment may lead to a denial.

What is the longest term for a home improvement loan?

Every lender will have different repayment phases, with the most typical for these forms of financing falling between 2 to 5 years. The longest term for an unsecured home improvement loan found during our research was 20 years. Remember, the longer you carry it, the more interest you’ll pay over the entire loan term.

Do you need an appraisal for a home equity loan?

In most cases, an appraisal is required when you apply for a home equity loan. The appraisal serves as an essential step in the loan approval process for several reasons:

  1. Establishing Home Value: An appraisal objectively assesses your home’s current market value. Most real estate markets see home values increase over time; if it’s been several years since you bought, you likely have gained equity simply through appreciation, no matter your current loan balance on the original mortgage. This valuation directly affects how much equity you can tap into. Generally, lenders allow you to borrow up to 80-90% of your home’s appraised value minus any outstanding mortgages.

Mitigating Risk: For lenders, approving a loan that exceeds the home’s actual market value poses a risk. If the borrower defaults, the lender must sell the property to recoup their losses. An appraisal protects the lender from extending too much credit against a home that may not be worth the loan amount.

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