Home Equity Loan vs. Home Improvement Loan

What Is a Home Equity Loan?

A home equity loan is a type of secured loan that allows you to borrow against the equity you've built up in your home. Your home equity is the difference between the current market value of your home and the outstanding balance on your mortgage. You build equity in your home naturally as you pay down your mortgage and your home's value increases over time.

Example: If your home is valued at $400,000 and you owe $250,000 on your mortgage, you have $150,000 in available equity. Depending on the lender, you can typically borrow 75% to 85% of that equity. In this case, your home equity loan could range from $112,500 to $127,500, based on the percentage the lender allows you to borrow, and not including closing costs.

Once approved, you'll receive the loan funds in a one-time lump sum and repay in fixed monthly payments over a set period of time. Home equity loans have a fixed interest rate, which means your payment amount will stay the same for the life of the loan. Repayment terms generally range from five to 30 years, giving you flexibility depending on your loan amount.

You can use a home equity loan for nearly anything including home improvements, debt consolidation or education expenses. However, it's important to remember that because your home serves as collateral for the loan, falling behind on payments could result in foreclosure.

What Is a Home Improvement Loan?

A home improvement loan is an unsecured personal loan specifically used to pay for upgrades and repairs to your home. Since it doesn't require any collateral, approval and terms are mainly based on your credit score, income and debt-to-income (DTI) ratio rather than your home's equity.

You can generally borrow up to $100,000, depending on the lender and your credit profile. The loan application and approval process is usually faster and simpler than a home equity loan.

Interest rates for home improvement loans are generally higher compared to home equity loans. Repayment terms are shorter, typically ranging from one to seven years.

Example: A three-year $10,000 loan at 7.99% would have a $313.32 monthly payment and total interest of $1,279.43. Extending the term to six years lowers your monthly payment to $175.28, but increases the total interest cost to $2,620.42.

As you can see, extending the loan term lowers your monthly payments but increases the overall interest cost you'll pay over time.

Tip: Some lenders offer a discount on your interest rate if you have a bank account with them and set up automatic payments.

Home Equity vs. Home Improvement Loan

Once you receive the funds, both loans operate similarly. You'll make regular monthly payments until the loan is fully repaid. However, there are some key differences in the two types of loans.

Collateral

• Home equity loan: Your home is used as collateral, securing the loan. Many lenders require you to have homeowners insurance.
• Home improvement loan: There's no collateral required. Approval is based on your creditworthiness and other factors, such as income.

Loan Amount

• Home equity loan: The amount you can borrow is based on your available home equity. Maximum loan amounts can vary depending on the lender and your home's value.
• Home improvement loan: Loan amounts are smaller since there's no collateral securing the loan. You can generally borrow up to $100,000 depending on the lender.

Interest Rate

• Home equity loan: Interest rates are fixed for the life of the loan and are typically lower because the loan is secured by your home.
• Home improvement loan: Interest rates are fixed, based on your credit score, loan amount and repayment term. Rates are usually higher compared to home equity loans.

Repayment Term

• Home equity loan: Repayment periods range from five to 30 years, offering more time to pay off the loan balance.
• Home improvement loan: Loan terms are shorter, typically from one to seven years.

Approval Process

• Home equity loan: The approval process is similar to the initial home purchase. Approval requires an appraisal and can take weeks.
• Home improvement loan: Approval is faster and doesn't require an appraisal. Some lenders even offer same-day approval.

Appraisal

• Home equity loan: Because the loan is secured by your home, lenders typically require an appraisal to verify your home's current market value and calculate your loan amount.
• Home improvement loan: An appraisal isn't needed since the lender doesn't use your home as collateral.

Closing Costs

• Home equity loan: The loan process is similar to a mortgage and includes a closing process where you sign paperwork and pay fees. Some lenders cover a portion or all of the closing costs.
• Home improvement loan: There's no need for a formal closing process, which allows you to move through the loan process faster. However, you could be charged origination and other fees.

Should You Get a Home Equity Loan or Home Improvement Loan?

Choosing between a home equity loan and a home improvement loan depends on the amount you need to borrow, how quickly you need the funds and whether you want to use your home as collateral.

Consider getting a home equity loan if:

• You need a bigger loan amount. Major home improvement projects such as full home remodels, additions or extensive repairs require a larger budget. Tapping into your home equity will allow you to access a bigger loan.
• You have substantial home equity. Ideally, you should have at least 15% equity in your home to qualify. Having more home equity allows you to maximize your borrowing power.
• You want lower interest rates. Since the loan is secured by your home, lenders typically offer more favorable rates compared to unsecured loans.
• You're comfortable using your home as collateral. Choose a home equity loan only if you're confident that you can keep up with payments. If you default, the lender could foreclose on your home.
• You want more time to repay the loan. Home equity loans have longer repayment terms allowing you to spread your payments over a longer timeframe.

Consider getting a home improvement loan if:

• You don't have much equity. If you're a newer homeowner, you may not have enough equity in your home to be approved for a home equity loan.
• You need funds quickly. There's no appraisal requirement, so approval time and funding is much faster with a home improvement loan. Some lenders even offer same-day approval.
• You're making smaller renovations. A home improvement loan is ideal for lower-cost projects like replacing doors or windows, a minor kitchen remodel or a deck addition.
• You don't want to use your home as collateral. Since the loan isn't secured by your home, there's no risk of foreclosure if you're unable to make payments. You also leave your home equity available for college expenses, debt consolidation or other major expenses.

How to Get a Home Equity Loan

If you decide that a home equity loan is the right option, here's how to get a loan:

1. Determine your equity. Subtract your mortgage balance from your home's current market value to calculate your equity. This gives you an idea of how much you can potentially borrow.
2. Compare lenders. Shop around with banks, credit unions and online lenders. Consider getting prequalified for a better idea of your possible terms. Compare interest rates, fees, repayment terms and borrowing limits to find the best fit.
3. Consider the risks. Remember that your home is collateral. If you fail to repay, you could face foreclosure.
4. Apply for the loan. Provide any documents requested by the lender. If you meet the lender's requirements, you may receive an approval and the lender will disburse your funds.
5. Use the funds wisely. Stick to home improvements or expenses that add value or provide long-term benefits to your home.

How to Get a Home Improvement Loan

If a home improvement loan better fits your needs, follow these steps to apply:

1. Estimate your renovation costs. Get detailed quotes for the work you plan to do so you can borrow the right amount.
2. Check your credit score. Good credit will help you qualify for a lower interest rate, reducing your overall loan costs. You can check your FICO^® Score^☉ for free through Experian.
3. Understand the loan terms. Review interest rates, loan terms, origination fees and other conditions before accepting an offer.
4. Budget for monthly payments. Make sure you can comfortably afford monthly payments without straining your budget.
5. Submit your application. Once you've chosen a lender and a loan, complete your application and wait for the final decision.

Frequently Asked Questions

The Bottom Line

Both home equity loans and home improvement loans can help you finance your home projects. Choosing the right one depends on your equity, credit score and financing needs. No matter which option you choose, having good credit will increase your chances of getting approved and qualifying for a low interest rate.

Start by reviewing your credit report and FICO^® Score. Looking over the information on your credit report will give you a better idea of what you should be doing to improve your score. Improving your score, in turn, could lead to more affordable monthly payments and thousands of dollars in interest savings over the life of the loan.