Home Improvement LoansCASAPLORERTrusted and Transparent
What are home improvement loans?
Home improvement loans can be a great source of funding to cover the costs of renovating, remodelling, and fixing your home. Most people think their only option is a personal loan; however, that is not the case. You can now get a variety of loan options from federal programs to a home equity line of credit. Home improvement loans have flexibility in terms of rates, repayments, terms, and even loan amounts.
There are 6 different types of home improvement loans, each with different guidelines, eligibility, and rates.
|Types of Home Improvement Loans|
|1||Home Equity Line of Credit (HELOC)|
|2||Home Equity Loans|
What is the best home improvement loan?
The best loan for your home improvement depends on your finances and the objective of the loan. If you do not have large savings and have a lot of equity in your home, then HELOC, home equity loans, and even cash-out refinance can be a great option. These loan options can offer low-interest loans as they are all backed by collateral. If the objective of the home improvement is for a single large project, then these loans would be the best alternative.
If you do not have home equity or do not want to put your home as collateral, then a personal loan would be ideal. Personal loans have lower interest rates than credit cards and can be used for large projects. However, they are required to be paid back within 2-5 years which is much sooner than the collateralized loans.
Credit cards would only be suitable for home renovations when there is an emergency such as a broken HVAC system. Credit cards can provide quick access to cash and can be paid back later. However, they are not suitable for large projects that extend for very long as credit cards have the shortest payback period compared to other loan options. Their high interest rates also make credit cards a very expensive alternative.
Lastly, federal programs combine mortgage programs and home improvement loans into one. It is important to note that federal renovation programs are more for increasing the suitability of the home rather than getting additional features like a pool.
6 Types of Home Improvement Loans
Home Equity Line of Credit (HELOC)
A home equity line of credit (HELOC) allows homeowners to borrow cash against their home equity, using the home as collateral. HELOCs function like a credit card, where a loan limit is pre-decided and the borrower can access funds from the HELOC, pay them back and choose to take the funds out again. The maximum amount that can be accessed using a HELOC depends on the amount of equity you own in the home and the loan-to-value (LTV) ratio permitted by the lender. Most lenders allow up to an 80% LTV ratio, which means you must have at least 20% equity in the home prior to the HELOC. For example, on a $400,000 home, you must own at least $80,000 ($400,000*20%) to be eligible for a HELOC.
For example, on a $400,000 home if your outstanding balance is $300,000 (you own $100,000), your LTV ratio is 75%. As you can borrow up to 80% LTV ratio ($320,000), the maximum HELOC loan amount you are eligible for is $20,000 ($320,000 - $300,000).
HELOC Limit Calculator
HELOCs are structured into two periods: the draw period and the repayment period. During the draw period, you are free to take funds out of the HELOC and are only required to pay back interest on any outstanding balance, not the principal. Once the draw period is over, the repayment period starts. During this period you can no longer borrow funds from the HELOC. Instead, you are required to pay back any outstanding balance which becomes an amortized loan and has regular monthly payments. To calculate how much your monthly HELOC payments will be, use our HELOC payments calculator.
Pros of a HELOC
- Funds can be borrowed as and when they are required
- HELOC fees can be waived by the lender
- Flexibility in repayments
- Interest payments can be claimed as tax deductions
Cons of a HELOC
- HELOCs use a variable rate where the interest rate moves with a benchmark index like the prime rate. This can make repayments unpredictable.
- Home equity of at least 20% is required
- Can result in overspending as initially only interest payments are required
- Home is collateral, so a payment default can result in foreclosure
Home Equity Loan
A home equity loan allows homeowners to borrow a lump-sum amount against the equity they own in the home. It is similar to a HELOC as the home is collateral, however, in a home equity loan you receive one amount at the beginning of the loan and cannot borrow more funds. The maximum amount you can borrow depends on the outstanding balance on the mortgage and the loan-to-value (LTV) ratio permitted by the lender. As the home is collateral, lenders can offer competitive rates as they have a lower amount of risk. Home equity loans are great for one-time large projects such as building a new roof or remodelling the kitchen. Most lenders allow up to an 85% LTV ratio.
For example, if you have a $300,000 home and your outstanding balance is $200,000, your current LTV ratio is 67%. As you can borrow up to 85% LTV ratio ($255,000) the maximum home equity loan amount you can borrow is $55,000 ($255,000 - $200,000).
Pros of a Home Equity Loan
- Competitive interest rates
- Predictable monthly payments based on the amortization schedule
- Fees can be waived by the lender
- Interest payments can have tax advantages
Cons of a Home Equity Loan
- Requires a credit score greater than 670
- Requires at least 20% home equity
- Second mortgage payment over the existing monthly mortgage payment
- Home is collateral
Cash-out refinance is the process of borrowing additional funds when you refinance your existing mortgage. When you refinance your mortgage, you essentially borrow the amount that is outstanding from your current mortgage with better terms such as a lower mortgage rate. For example, if your existing mortgage has an outstanding balance of $300,000 and you wish to refinance, you will get a new mortgage with better terms for $300,000 which pays off the outstanding balance of the first mortgage, thereby replacing it.
Now, in a cash-out refinance you borrow more than the outstanding balance on your existing mortgage, pocketing the difference. For example, in the same example with $300,000 you can choose to cash-out $15,000 for home improvements. The total refinanced loan amount will be $315,000 as shown in the figure below.
The total amount that can be borrowed as part of the cash-out refinance is determined by the loan-to-value (LTV) ratio. Most lenders allow up to 80% LTV ratio following which the outstanding balance is subtracted. To calculate the maximum amount you are eligible to borrow use our cash-out refinance calculator.
Pros of a Cash-out Refinance
- Lower mortgage rate
- Single mortgage payment
- Repayment term is the refinance term which can be 30 years if required
- Interest payments can be used as tax deductions
Cons of a Cash-out Refinance
- Refinance fees
- Home is collateral
- Private mortgage insurance (PMI) is required if LTV ratio > 80%
- Debt-to-income (DTI) ratio needs to be < 43%
A personal loan is a loan where a lump-sum amount is borrowed without any collateral. If you do not own enough home equity and have an LTV ratio greater than 80%, then a personal loan will be the best option for your remodelling needs.
Personal loans can get you the funds relatively quickly as the home is not part of the loan. However, the interest rate charged on a personal loan is higher than a HELOC or a home equity loan as there is a higher risk for the lender. Personal loans can be fixed-rate or variable-rate. Fixed payments are more predictable whereas variable-rate constantly changes with a benchmark index like the prime rate which is connected to the Fed funds rate. These loans usually have to be paid back within 2-5 years and have closing costs too. Personal loans are best used if you have to do an emergency repair where time is a crucial factor such as heating or cooling system repair. Use our personal loan calculator for home improvements to determine your monthly payment.
Pros of a Personal Loan
- Quick application process with funds available within days
- No collateral required
- Perfect for unforeseen repairs
Cons of a Personal Loan
- Interest rate is heavily dependent on credit score
- A smaller amount can be borrowed as compared to HELOC or home equity loans
- Shorter repayment period
- Prepayment penalties and late fee penalties
- No tax deductions on interest paid
Credit cards let you borrow funds for a short period of time and can be great for emergency renovations that are required. You are only required to make the minimum payment to your credit card account if you are strapped for cash. Interest starts accruing on the account if you have an outstanding balance after the last date to make the payment. Credit cards have relatively high-interest rates as compared to the other loan options because it poses a higher risk for lenders as there is no collateral.
Pros of a Credit Card
- Payment flexibility
- Quick application
- Interest-free grace periods
Cons of a Credit Card
- Very high-interest rates
- Fee for credit card
- Low borrowing limits on credit cards
The government offers some low-cost solutions to individuals who qualify for their home renovation programs. Different government agencies have different programs, therefore, if you qualify for an FHA loan, VA loan or a USDA loan be sure to check if you are eligible for additional assistance for home renovations.
FHA loans offer the FHA203k which is a special FHA loan where the borrower receives their mortgage amount and an additional amount for renovations. The home being purchased must be approved by the FHA as a home that requires renovations to ensure safety and livable standards in order to receive the additional amount. The amount that can be borrowed for renovations can go from $5,000 to $35,000 depending on the condition of the home. A VA renovation loan is similar to an FHA203k loan where the borrowing amount will include both the mortgage amount and funds for renovations. Similarly, the USDA has a program known as the USDA Rural Housing Renovation Loan Program which caters to individuals who purchase homes that are in need of renovations.
Pros of Federal Programs
- Low-interest rate
- Part of the mortgage
- Several grants available
Cons of Federal Programs
- Strict eligibility requirements
- Not all lenders can make these loans
Frequently Asked Questions (FAQ)
What credit score do I need for a home improvement loan?
Different loan programs have different requirements. However, a majority of loans will require a minimum credit score of 620.
Federal programs have different requirements. FHA203k loans can go as low as 500, while VA loans and USDA loans do not have minimum credit score requirements.
Are home improvement loans tax-deductible?
Yes, a few of the loan programs are tax-deductible as interest payments on HELOCs, home equity loans, and cash-out refinances can be claimed as tax deductions. Personal loans and credit cards cannot be claimed. The interest payments on your mortgage through a federal loan program can also be claimed as an itemized deduction.