If you’ve been living in the same house for a number of years, it is but natural to want to change things around a bit. Maybe spruce up the master bedroom, add a sunroom, or convert the old basement into a den.

Sometimes, you may want to renovate the entire home. However, home improvements aren’t particularly cheap. The national average cost of a home renovation is pegged at around $46,820 and may go up to $200,000. Unless you’ve been prudently saving money over a period of time, you’re going to need help financing the project. Before you dive into the deep end, let us answer the most important question. How do home improvement loans work and what you should choose?

Before we go into the types of financing you could choose from, there is a little bit of introspection you ought to indulge in. 

Can you afford it?

Sure, you really want to renovate your home. But can you afford to take on another monthly payment right now? To answer that question, you will need to take a look at your monthly income, your expenses, the scope of your renovation, the return on investment on your project, and how long your project will take.

If your financial situation is in the pink, and if the home improvement you have planned will add value to your home, taking a loan to finance the project is a good idea.

Now that you’ve crossed that bridge, let’s introduce you to your options.

Types of loans

Speaking broadly, there are two types of loans you could choose from.

1. Unsecured loans

These are loans that do not require collateral but will usually have a smaller window for you to pay back the lender and a higher rate of interest. Defaulting on paying back unsecured loans will have a negative impact on your credit score.

2. Secured loans

Lenders will require collateral from you for you to be eligible for a secured loan. In the case of home improvement loans, your house will be used as collateral. 

The positive aspect of secured loans is that the interest rates charged are considerably lower than unsecured loans, and the payback window is also longer. The downside to secured loans is failing to pay back the loan as per the agreed schedule is that the lender has the option to foreclose on your home, even if your mortgage payments are on schedule.

Unsecured loans

1. Credit cards

If the scope of your home improvement project is minor, like replacing bathroom cabinets or window treatments, using your credit card is probably the most convenient way to pay for it.

A lot of credit cards offer you an interest-free time period to repay what you spend. If you qualify for a zero percent APR card, you could pay for minor home improvements without paying any interest at all. Other credit cards offer additional perks like airline miles, cash back, and other rewards, depending on how much you spend.

There are, however, quite a few risks associated with paying for large home renovation projects with credit cards. For one, if you fail to pay back the borrowed amount within the interest-free period, the interest rates will be considerably higher than other home improvement loans. Those interest rates are also liable to change the longer you take to repay your credit card bills. And like we mentioned earlier, a bad repayment history will directly affect your credit score.

2. Personal loans

A lot of banks, credit unions, and online lenders offer unsecured personal loans specifically for home improvements, calling them home improvement loans. 

Processing personal loans are usually quick and hassle-free. Lenders will look at your monthly income as well as your credit score and let you know how much you qualify for. A lot of them will credit the loan to your bank account within a day.

Personal loans are ideal for small to medium-sized renovations, considering they have smaller loan limits, higher interest rates, and faster repayment timelines than secured loans.

On the downside, the poorer your credit score, the higher the interest rates charged. A lot of lenders also have a lot of additional fees, like application fees, prepayment penalties if you want to close the loan earlier, and late payment fees. 

If you’re planning on applying for a personal loan to fund your renovation project, make sure you look at multiple lenders and choose the one that offers you the best interest rates, repayment terms, fewer fees, and a quick payout.

3. Government loans

Government-approved loans such as the FHA Title 1 are fixed-rate loans for home improvement offered by FHA-approved lenders. These loans fall under both secured and unsecured loans.

Some lenders offer up to $7,500 with no collateral. Others offer as much as $25,000 even if you have little or no equity in your home, as long as the money is used for renovations aimed at improving the quality of living, and the home has been occupied for at least 90 days. This makes it the ideal loan for new homeowners looking at making improvements.

A single-family home can get a repayment window of up to 20 years, and the interest rates are as low as 2.8% per annum.

Defaulting in paying these loans may, however, lead to foreclosure on your home. However, since these are government-approved loans, there is usually a pre-foreclosure period, during which homeowners may sell the home or come up with the amount due by other means to avoid foreclosure.

Secured loans

1. HELOCs

Home equity lines of credit, or HELOCs are secured home improvement loans that are the ideal choice for long, ongoing renovation projects.

The amount of loan that you will be eligible for will depend on the amount of equity you have in your home. Simply put, equity is your total home mortgage value subtracted by what you’ve already paid back.

There are multiple advantages to choosing HELOCs as a home improvement loan.

For one, you can withdraw and use small portions of the sanctioned loan amount as and when you need it. 

As a secured loan, your rate of interest will be low and the repayment window will be longer. 

However, most HELOCs have variable rates of interest, which means your payments could increase with market fluctuations. Failure to repay your HELOC could result in foreclosure on your home.

2. Home equity loan

If you know the exact cost of your home improvement plan and how long it will take, you could choose a home equity loan, also known as a second mortgage, instead of a HELOC.

Home equity loans are fixed interest secured loans that are paid in a lump sum and repaid in fixed monthly payments. As with all secured loans, interest rates will be lower and the repayment window, longer than unsecured loans.

However, falling back on payments with home equity loans will have the same repercussions as with all secured loans that use your home as collateral. You risk foreclosure.

3. Mortgage refinances

Replacing your current mortgage with a new one at a new interest rate is known as mortgage refinancing. There are a couple of options when it comes to refinancing for you to choose from.

A cash-out refinance will give you a loan amount larger than the previous mortgage, meaning you can clear all your old dues and have some cash left behind, which you could use to finance your renovation.

A rate and term refinance scheme may give you lower interest rates or a more favorable repayment schedule, but might not put as much cash into your pockets as a cash-out refinance.

There are several downsides to refinancing. For one, you will need to bear the costs for an appraisal, closing costs, origination fees, and other taxes. And unless you choose a smaller repayment schedule than your previous mortgage, you will end up extending the term of your loan, eventually paying back more. Ideally, you ought to choose mortgage refinancing only if you get a lower rate of interest than your current mortgage.

What to choose

So how do you know which one is the best choice for you? Let’s quickly summarize to help you choose.

  1. If the scope of work is small, use a credit card, preferably a zero percent interest APR credit card.
  2. In case you’re planning a detailed and lengthy renovation and have good equity in your home, HELOCs or home equity loans are the way to go.
  3. If you’re planning a mid-sized renovation, have excellent credit, and don’t want to put your home down as collateral, get a personal loan, just as long as you can adhere to the repayment schedule.
  4. In case you’re looking at improving the livability of your home, or if you’re a new homeowner, a government-approved FHA Title 1 loan is your best choice.
  5. If you’re getting a lower rate of interest than your current mortgage rates, choose mortgage refinancing.
How do home improvement loans work and what to choose was last modified: February 26th, 2021 by Narayan Shrouthy