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Your home may need some love and attention that you can't afford to pay for out of pocket. When you find yourself in that situation, you may consider taking out a home improvement loan.
It's the answer to a lot of homeowners' problems: If you have a leaky roof that insurance won't pay for, you probably can't wait indefinitely to repair it. But using a loan to cover home improvement costs comes with risks and benefits, and it's important to make sure you understand them before moving forward with a loan.
It also may be helpful to keep in mind that there isn't just one way to finance a home improvement project but several—but each choice has its pros and cons.
What Is a Home Improvement Loan?
A home improvement loan is just what it sounds like: money lent to you that is used to make improvements to your home. But "home improvement loan" is a broad term. Often, lenders advertise a loan as a home improvement loan, but also mention that you can use the money for whatever you want, including taking a vacation or paying off debt.
In other words, there are a lot of different types of home improvement loans. Here are some to consider.
Home Equity Loan
In this case, you'll receive a loan based on the equity in your home. You'll get a lump sum of cash that you can then use for home improvements, and typically, you'll pay back the loan in installments with a fixed interest rate.
While you can spend a home equity loan on nearly anything, it arguably makes the most financial sense to put money you borrow from your home toward fixing up your home and adding value to it.
Home Equity Line of Credit (HELOC)
A home equity line of credit (HELOC) is a line of credit whose limit is based on the equity in your home. You get a draw period—typically 10 years—to take from that line of credit and spend on your home. During that 10 years, you are only required to pay back the interest on the money you've borrowed. Once the draw period ends, you enter repayment—often 20 years—during which you pay both principal and interest.
HELOCs generally come with a variable interest rate, so the amount you pay will fluctuate based on market rates. Like a home equity loan, it's typically recommended that you use the home equity line of credit to pay for home improvements or perhaps an emergency rather than funding anything else.
If you're going to finance a home improvement with a cash-out refinance, you'll take out a new, bigger mortgage loan on your home. Your previous mortgage is paid off using the new loan, and you get the excess cash, which you can use to pay for home improvements or home repairs.
FHA 203(k) Loan
An FHA 203(k) loan is offered by the Federal Housing Administration; it's a federal loan program in which you'll be given money to buy a house and do renovations. These loans are for fixer-upper homes, and the lender will verify that the money is being used for repairs.
Many borrowers take out personal loans to make home improvements. Generally, these are unsecured loans—meaning there's no collateral attached to the loan—and you pay back the loan in fixed installments.
Sometimes a contractor, like a roofer or window replacement company, will offer a loan, generally with a bank they work with. Like with other types of loans, you'll repay the loan in installments.
Pros and Cons of Home Improvement Loans
Before you take out any loan, it's always prudent to weigh the pluses and minuses. After all, you already have a mortgage. You may also have a car loan or student loans. Taking on another loan is yet another responsibility. It's important to find out if doing so makes sense in your situation.
- Adding value to an asset: You are improving what is probably your most expensive asset: your home. If you're making home improvements, you're likely adding value to your home, and at the very least, you're taking care of your house and keeping it well-maintained.
- Improved quality of life: If you can use a home improvement loan to make your home nicer, you may feel that it's worth paying off the debt to get projects finished now rather than waiting a few years to save up the money.
- Potentially reduced tax bill: Some home improvement loans may reduce your tax bill. Home equity loans and lines of credit may be deductible if the money is used to buy, build or substantially improve your home. This deduction is subject to certain limits and conditions, so check with a tax professional to see if yours qualifies.
- Adding to your debt: You may find yourself over-leveraged, where you've taken on too much debt.
- Risking your house: If you get a secured loan, such as a home equity loan, HELOC or cash-out refinance, you're using your house as collateral. In a worst-case scenario, if you fall behind on payments and can't catch up, you could lose your home.
- May not add value: The home improvements may not add value to your home, or enough to justify taking out an expensive loan.
Are There Better Ways to Pay for Home Improvements?
It's a judgment call on whether there are better ways to pay for home repairs and upgrades than a home improvement loan. But if you are looking for alternatives, there are plenty, including:
- Tap your savings. If you have money in your savings account, you might feel justified raiding it for important home improvements.
- Create a special savings account. You can always set up a sinking fund to save for home improvements. You pick a month and year when you want to get the home improvement done, and then decide how much you think the home improvement will cost. If you think you need $10,000 for a new roof, and you think you can wait for five years, you put aside $166 a month for the next five years (60 months), and you'll have roughly $10,000 in a savings account. Creating a sinking fund takes time, but you won't go into debt.
- Earn more income. Just as some people take on side hustles to pay off debt, you could take one on or get a part-time job to create extra income for home improvement projects.
You could also do a combination of all the above strategies. Set up a sinking fund for a portion of the money you need, raid the savings account for another portion, and, if there's still a shortfall, then apply for a small personal loan for the rest.
The Bottom Line
Home improvement loans ultimately can make your home a nicer place to live, and can make it worth more when it comes time to sell. But if your finances can't handle another loan or the payments and interest don't make sense with your budget, you could end up wishing you hadn't bothered applying for one.
That's why you'll want to make sure you apply for a home improvement loan with as low of an interest rate as you can possibly get. Start by checking your credit report and credit score to see where you stand. If your credit score isn't where you'd like it to be, take steps to improve it before applying for a home improvement loan.