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A home improvement loan can help you finance important renovations. Before you apply for one, however, first you need to determine which type of loan is best for you.
Most home improvement loans are generally designed for borrowers with good credit or better. There are, however, also options for homeowners with fair credit. Keep reading to learn more about what's required for a home improvement loan and what options are available.
What Do I Need for a Home Improvement Loan?
It's ideal to have at least good credit when applying for a home improvement loan, so the first thing you'll need to do is to check your credit score. To give you an idea of where you want your score to be, here's how FICO breaks down its credit score ranges:
- Exceptional: 800 to 850
- Very good: 740 to 799
- Good: 670 to 739
- Fair: 580 to 669
- Poor: 300 to 579
You'll also need to make sure you have documents that verify your income, such as pay stubs or a W-2, or bank statements and recent tax returns if you're self-employed.
If you're planning to get a loan based on your home's equity, you'll also typically need to get an appraisal done on the home to determine its value and the amount of equity you have based on what the home is worth and what you have left on your mortgage loan.
Home Equity Loans and HELOCs
One of the most common ways to finance home improvements is through a second mortgage in the form of a home equity loan or a home equity line of credit.
Both are designed for homeowners who have at least 20% equity in their homes, and the debt is secured by the home itself. As a result, home equity loans and lines of credit typically offer lower interest rates than other loan types, especially unsecured loans.
If you use loan funds from a home equity loan or line of credit to buy, build or substantially improve the home used to secure the debt, you may be able to deduct some or all of the interest paid on your tax return.
Home equity loans and lines of credit are best if you're confident in your ability to repay the debt on time. Here's what you need to know about each one.
Home Equity Line of Credit
A home equity line of credit, also called a HELOC, typically comes with a variable interest rate that can fluctuate along with market rates. These typically start out lower than the fixed rate you might get with a home equity loan, but over time the variable rate can increase and potentially cost you more in the long run.
As a result, HELOCs are best for people who plan to pay off their debt relatively quickly. By doing this, you can take advantage of the lower initial variable rate and eliminate the debt before that rate goes up too much.
HELOCs are also good for homeowners who have ongoing renovation projects. Instead of giving you the full amount of the loan upfront, the lender allows you to revolve a balance, taking out debt and paying it off over and over again.
Home Equity Loan
A home equity loan provides borrowers with the full loan amount upfront and a fixed interest rate. Depending on the loan terms, you may have between five and 30 years to repay the debt.
Because home equity loan interest rates stay fixed for the life of the loan, they're best for homeowners who plan to pay off what they owe over a long period. They're also excellent for borrowers who have just one home improvement project and don't need to revolve a balance.
Other Loan Options for Improving Your Home
While home equity loans and HELOCs can provide an inexpensive form of financing, they're not always the best solution.
Because they're secured by your home, the lender can foreclose on your home if you default on your payments, forcing you to sell it so the lender can recoup the amount you owed.
If you'd rather not risk the roof over your head, alternatives include cash-out refinancing and personal loans.
Instead of taking on a second loan, a cash-out refinance will refinance your existing mortgage and essentially cut you a check for the amount you want to cash out.
Your new loan will include the initial mortgage balance plus the cash-out amount and any closing costs you might have rolled into the loan.
A cash-out refinance gives you the opportunity to finance your home improvement project over a long period of time. And if mortgage rates have dropped since you first bought the house, you may also be able to get a lower rate on your debt overall.
The main downside to a cash-out refinance is that you'll pay closing costs on the full loan amount instead of just the cash-out amount. With a home equity loan or HELOC, closing costs only apply to the funds needed for your renovation.
Depending on the lender, you can do just about anything you want with a personal loan, including financing a home improvement project.
Personal loans are typically unsecured debt, so you don't have to use your house as collateral and put your homeownership at risk. Also, you don't need to have a specific amount of equity in your home to qualify for a personal loan, and you may be able to qualify for a decent interest rate even if you have fair credit.
There are, however, some drawbacks that go with using a personal loan over a loan backed by your property. For starters, personal loans typically have much shorter repayment periods than home equity products and cash-out refinance loans.
While lenders' terms vary, you can generally expect to have anywhere between one and seven years to repay the loan, based on the original loan amount. Also, personal loan interest isn't tax deductible, even if you're using the funds to improve your home.
Finally, unsecured personal loans typically charge higher interest rates than secured loans. So if you're planning a big project and needs thousands or even tens of thousands of dollars, you may want to go with a less expensive option.
How to Get the Right Loan for Your Home Improvement Project
There's no single best way to finance home renovations, so it's important to know what you want and your plans to pay off the debt.
If you know you'll be able to pay off the new loan in a relatively short period of time, it may be better to opt for a home equity loan or HELOC, which will provide cheaper rates than personal loans.
If, however, you also want to refinance your mortgage to take advantage of lower mortgage rates, it may make sense to do a cash-out refinance and stick with one loan instead of two.
That said, any of these loans can have serious consequences if you're unable to repay them on time. And if you have fair credit, you may have a hard time qualifying for a low rate, if at all.
If you want to avoid the negative consequences of a loan secured by your home or have fair credit, a personal loan may be your best bet.
Regardless of which loan you choose, it's essential to take the time to shop around to get the best deal. If you're looking to do a home equity loan, HELOC or cash-out refinance, start by checking with your existing lender to see what terms they can offer.
Depending on your overall relationship with the lender, you may qualify for special terms or discounts. Even if you do, compare the offer with other mortgage and home equity lenders to see what terms and features they bring to the table. Specifically, look at interest rates, fees, closing costs and repayment terms.
If you're looking for a personal loan, compare terms from traditional banks, credit unions and online lenders to determine which offer is best. Many lenders will allow you to get prequalified and review your offer without officially applying for the loan.
In addition to checking interest rates, also look at whether the lender charges an origination fee or a prepayment penalty. Also, consider how long each lender will give you to repay the debt and whether you can afford the monthly payments.
Should You Finance Your Home Improvement Project?
If you're already thinking about how to get money to fund your home renovation, you've likely already considered whether it's the right course of action in the first place.
If not, take the time to think about whether you should borrow money for this particular endeavor and if there are other alternatives you might want to try first.
For example, if you only need a few thousand dollars or less and have good cash flow, it may be better to wait and save for the project and avoid adding new debt altogether. And if you have fair credit and may not get access to a favorable rate, you could consider asking a family member or friend for a low-cost loan while you work on improving your credit.
Whatever you decide, take the time to consider all of your options and pick the best one for your specific financial situation.
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