LIs your kitchen still in the 1990s? Perhaps your roof could use some work, or your family is growing and you need more space. Home renovations can be necessary for a number of reasons, but they are rarely cheap. When your savings don’t cover the cost of a new deck or a bathroom remodel, you may look for financial assistance.
Home improvement loans are not singular products but describe various ways to borrow funds for renovations or repairs. Finding a home improvement loan comes down to your financial situation, the amount of equity in your home, and the size of the renovation project. This guide provides the information you need to understand what home improvement loans are, the types of loans available, and the best options for your financial situation.
What do home improvement loans cover?
Home improvement loans cover the cost for labor and materials to complete renovations. Some loans are unsecured meaning they do not use collateral, while others are secured, meaning your home is collateral.
There are two main kinds of loans: unsecured loans and secured loans. Unsecured loans, like personal loans, are based on your creditworthiness. On the other hand, secured loans like home equity loans consider the value of your home. The right option really depends on how much you need to borrow and how willing you are to use your home to secure the loan.
Common types of home improvement loans
There are different types of home improvement loans, and it’s important to understand the unique aspects of each type of loans.
Personal loans
Personal loans are a type of unsecured installment loan. You receive a lump sum of money, and then repay the loan over a certain period of time with a fixed interest rate. Because the loans are not secured to any property, you need a good credit score in order to get the loan. These loans are typically funded much faster than loans based on home equity, so they are a popular choice for a mid-sized home improvement projects like replacing windows or doing some cosmetic updates.
Home Equity Loans
Home equity loans are often referred to as “second mortgages” because they allow you to borrow money against the equity you have built in your house. You take the money as a single lump sum and you pay it off with a fixed interest rate. This means you will have the same payment each month which can help you to budget your payment. However, since your house is used as collateral for the loan, the lender can take your house if you don’t pay the loan back.
Home Equity Lines of Credit (HELOCs)
A HELOC is different from a traditional loan because it in some ways works like a credit card. You are given a credit line that you can draw from during a “draw period” which is usually about 10 years. You only have to pay interest on the money you use. After the draw period, you enter the repayment period where you pay back the principal as well as interest.
HELOCs usually come with variable interest rates according to the Consumer Financial Protection Bureau (CFPB). This means your interest rates can change and as a result your monthly payments can change. This can be a great option for projects that are flexible because it allows you to pay interest on the principal, however, it does introduce some risk with the changing interest rate.
Cash-Out Refinance
With this option, you would replace your current mortgage with a larger one, and they will give you the difference in cash. This makes sense if the current mortgage rates are lower than the current rates you are paying. You will reset the mortgage term and this will involve additional closing costs.
FHA 203(k) Rehabilitation Mortgage
These are backed by the federal government and for people buying or refinancing “fixer-uppers”. The Federal Housing Administration (FHA) backs these loans that allow you to finance the purchase of the house and the renovations into the same mortgage, making it easier for older homes that need structural renovations or modernizations.
How to qualify for financing
A variety of factors are considered by lenders when making a decision about the loans that have available.
Credit Score: The higher the score you have, the lower the interest rates you qualify for. These personal loans are good when you have good to excellent credit to get the best terms. FHA loans are less strict normally though.
Debt-to-Income Ratio (DTI): The lower the DTI, the better, because that means you have a bigger income relative to the existing debt that you have, and that means you are more likely to be able to afford the added loan payments.
Equity: With secured loans such as HELOCs and home equity loans, you typically need to have considerable equity in your home—often at least 15% to 20%—remaining after the loan has been taken out. \
Income Verification: Steady income has to be proven through pay stubs, tax returns, or bank statements. \
Best practices for borrowing \
Taking on debt for a renovation is a big financial commitment. Following guidelines can make it less risky for your finances. \
Establish a thorough budget
Do not borrow based on an estimate. Obtain firm quotes from contractors and do the pricing for materials before applying. During construction, unexpected expenses are almost certain to occur, so it is wise to add a 10% to 20% buffer for this. \
Explore options
Do not just take the first offer. Assess multiple lenders for interest rates, fees, and repayment terms as well as the first offer. The life of a loan could be impacted by a small difference in the interest rate and this could save you thousands of dollars.
Review the tax implications
The interest on home equity loans/HELOCs may be tax deductible in some cases. IRS regulations state this applies only when the loan is taken out to “buy, build, or substantially improve” the home tied to the loan. Before making a determination, speak to a tax professional to check if your home improvement loan is tax deductible.
Mistakes to Avoid
Smart borrowing requires some effort. Here are the most common mistakes to avoid.
Borrowing More Than You Should
Once you are able to tap into funds, you may be tempted to broaden the scope of your project. This is known as overborrowing, and it places you at risk of losing equity in your home. More importantly, it increases your monthly financial commitments. Stick to the plan.
Don’t Fall for Contractor Financing Scams
If a contractor is persistent about you using a particular lender or pushes you to sign documents you have not read, be cautious. The Federal Trade Commission (FTC) warn of scammers who attempt to have you sign blank documents, or agree to predatory loans that have high interest and strip equity from your home. Always read the documents carefully and don’t let the contractor pressure you into financing.
Disregarding closing costs and fees
Loans can come with various costs that can get charged when you get a loan including appraisal costs, origination fees, and even closing costs. These can significantly reduce the money you have available for your renovation. Make sure you understand the “Annual Percentage Rate” (APR) before just looking at the interest rate. This value includes the costs mentioned above.
Improving value wisely
A home improvement loan can be an effective way to make renovations that can help your home reach its potential. If you prefer the speed of a personal loan, the certainty of a home equity loan, or the flexibility of a HELOC, the most important thing is to be sure that the financing aligns with your goals. When you know and control the costs of borrowing, you can add value to your home and make sure that your investments don’t put your financial future at risk.