Outdated houses can be a pain to live in and difficult to sell, prompting U.S. homeowners to spend billions of dollars annually on renovations and improvements. The high cost of all that remodeling and upgrading drives a huge demand home improvement loans.
If you’ve decided that the kitchen needs a do over or those teal-colored bathroom oozes 1975, two big challenges await:
- Finding a contractor you can afford
- Raising the cash to pay the guy
Though you can try asking your rich Uncle George for a loan, most renovators opt to borrow, often using equity in their houses as collateral. Others search for an unsecured loan from a bank, credit union or online lender. Those with really high borrowing limits will use a credit card to pay for it..
Qualifying for an unsecured loan, also called a personal loan, can be difficult since lenders don’t have collateral to seize if you default. Most lenders are less worried about how you spend the money than the risk they’ll run if you don’t pay them back. To compensate for risk, they generally charge substantial interest, demand a strong credit score and want to know a good deal about where you earn your income.
Using an unsecured loan for home improvements can be the best, and perhaps the only, way to raise the needed cash for those who can’t use their house as collateral. This group includes first-time homebuyers who ran through their savings to make a down payment and those who haven’t paid down enough of their mortgage to satisfy lender underwriting requirements.
A far more cost-effective alternative for people who have paid down a sizable chunk on their mortgage debt is a home-equity loan or line of credit. Unsecured loans carry annual interest rates of more than 30% in some cases, but home equity loans and HELOCs generally are in 6% range in 2019. Though lenders will still want to know a good deal about your income, creditworthiness and possibly your other investments, the lower cost of loans that use your home as collateral can save you thousands of dollars.
Before deciding what type of loan works best for you, do your homework. You should consider how much a home improvement is likely to add to the value of your home. Many web pages will estimate how much of your investment you are likely to recoup if you sell your house. You might also ask a real estate broker in your area to estimate the value of an improvement.
Once you’ve decided to move ahead, seek estimates from contractors and do you best to check their backgrounds. Having the money to pay for the work is important, but good work done on time can be the key to a well-executed job.
Raising the money is the next step, and you should consider the alternatives carefully. Unsecured loans take many forms. They come with various repayment terms, interest rates and creditworthiness requirements. Generally, the better your credit, the more favorable the terms. Conventional lenders such as retail banks offer unsecured loans, as do a variety of online lenders. Most unsecured loans must be repaid in two to five years and there usually is a cap on how much you can borrow.
If you can’t find an unsecured loan that meets your needs or budget, a home equity loan or HELOC might be a better option. HELOCs were very popular during the years before the real estate market collapsed in 2008. Soaring home prices boosted home equity and lenders’ underwriting standards were loose for approving equity loans or lines of credit. That has changed. Lenders today have stricter limits on how much they’ll lend relative to the equity you have in your home.
One other advantage to home equity loans, often called second mortgages, and HELOCs is tax deductibility. Until the 2018 tax year, interest on these loans was tax deductible, but that has changed slightly. If you use the equity loan or HELOC to upgrade your home, you can deduct up to $750,000. If you use it for personal expenses (paying off student loan or credit cards), it’s not deductible.
You also should be confident you can repay the loan since it uses you home as collateral. If you default, the lender can try to foreclose on your property. Finally, you should remember that an equity loan or credit line reduces whatever equity you’ve built in your home.
Home equity loans generally have longer repayment schedules than personal loans. HELOCs often don’t require that you repay principal for a time. A 30-year HELOC might be interest-only for the first 10 years and allow you to borrow against you credit line however you wish. But after years, the credit line is frozen, and you must begin paying off what you borrowed with interest.
No matter which type of loan you choose, remember that approval can take time. Home equity loans almost always require appraisals of your home’s value and come with paper work that is filed as a public record just like a primary mortgage. It’s a good idea to start the process weeks before home-improvement work begins. Alternately, you can seek pre-qualification that will make it easier to complete the application when you need the money.
How Loans Work
Here is an example of how a home improvement loan works:
Sally and Sam own a suburban home with a market value of $500,000 which they bought in 2010. They have made enough payments that they now $200,000 equity. They want to remodel the kitchen, a job they expect will cost about $30,000. They’re trying to decide whether to apply for an unsecured personal loan or a home equity loan.
If they apply for an unsecured loan, they estimate they can borrow $20,000 and will use $10,000 from savings. After checking several lenders online as well as their community bank, they determined that the best interest rate available was 12.4% annually for five years. That means payments of $449 a month for five years for a total payoff of $26,940 with $6,936.53 of that being interest.
A home equity loan requires more paperwork. Each of the three lenders the couple contacted agreed to waive closing costs, documentary stamp tax fees and appraisal costs, so they are only concerned with how much they will be charged in monthly payments. They would take a loan with a 20-year repayment term at an interest rate of 5.5%, which results in a $136.95 monthly payment. If they repaid the loan on schedule, they would owe the lender $33,143.09 with total interest of $13,143.09.
That’s almost twice as much interest for a 20-year home equity loan as you would pay for a five-year personal loan.
Both loans allow for extra payments and an early payoff as options. Accelerating loan payments on either loan would reduce the balance owed and mean lower total interest payments.
Other options exist for borrowing home-improvement money.
- If you can join a credit union, you might be able to get a personal loan at a lower interest rate than what is available from online lenders and retail banks. By law, credit unions can only charge a maximum annual interest rate of 18%, an attractive rate compared to the 30% or more than some online lenders charge borrowers with less than sterling credit scores. Credit unions obviously are attractive places if you have bad credit.
- Government programs offer loans for home renovation. The Federal Housing Administration has two programs. The first, Title I, authorizes approved lenders to make home improvement loans based on market rates and borrower creditworthiness through a program called 203k. It also sponsors the Energy Efficient Mortgage program, providing financing for energy-saving enhancements such as solar panels, insulation and duct work.
- Primary mortgage refinancing might be an option, particularly if mortgage rates have decreased since you took out your current mortgage. You can apply for a new mortgage, borrowing more than you now owe and use the extra money to cover the renovation costs. Primary mortgage interest payments are usually tax deductible.
- Credit cards are another option but should be used cautiously. If you have excellent credit, you can often find a credit card offer that allows you to borrow at low or no interest for 12-18 months or more, giving you time to pay down what you borrowed. Keep in mind that after the grace period, interest rates could jump to 20% or more on unpaid balances. As a general rule, only consider using credit cards to finance small projects that you can repay in a short amount of time.