What Are Home Improvement Loans and How Do They Work?

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Many home renovation daydreams are swiftly crushed by the associated price tag. Homeowners can pay cash for some small-scale repairs, but other upgrades can add up to thousands of dollars and require other funding. That’s where home improvement loans come in. Home improvement loans are something of a misnomer, as […]

Many home renovation daydreams are swiftly crushed by the associated price tag. Homeowners can pay cash for some small-scale repairs, but other upgrades can add up to thousands of dollars and require other funding. That’s where home improvement loans come in.

Home improvement loans are something of a misnomer, as they’re actually different types of loans or lines of credit that can be used to fund all kinds of home repairs, from structural damage to room remodels and even energy-efficient or accessibility upgrades. Find out how these loans work and what type of home improvement financing is best for your renovation projects.

Table of contents

How Do Home Improvement Loans Work?

You can finance home improvements with unsecured or secured debt:

  • Unsecured debt doesn’t require collateral. Personal loans and credit cards fall in this category. Lenders offset risk by charging significantly higher annual percentage rates (APR).
  • Secured debt requires collateral–a financial asset that insures the lender against loss if the borrower defaults on payments. Your car, mortgage, investments, or savings are all considered assets, but their use as collateral depend on their value, the lender and loan type. To qualify for secured home improvement loans like cash-out refinance, FHA loans and home equity loans, you need to put the property itself as collateral.

FHA 203(k) Rehab Loan – Best for rehabilitating damaged properties

An FHA 203(k) Rehab Loan is an all-in-one loan insured by the Federal Housing Administration (FHA) tailored for homes in dire need of renovation. Borrowers can purchase a fixer-upper and finance its repairs under a single loan instead of applying for a mortgage loan and a renovation loan separately. Homeowners who wish to renovate a current property can also apply for this loan by refinancing their existing mortgage.

This loan type allows you to finance the purchase of run-down properties a private lender wouldn’t consider otherwise. With FHA-backing, homeowners benefit from lower interest rates, and lenders are insured against risk even before the home’s value is properly assessed.

The FHA offers two types of 203(k) loans:

  • Standard 203(k) for major repairs
  • Limited 203(k) loan meant for minor renovations

FHA 203(k) loans have specific eligibility requirements and limitations. To start, it is only applicable for residential properties that are at least one year old and made up of 1 to 4 family units. Borrowers also can’t build a home from scratch but can demolish or raze a structure as long as the property preserves its foundation.

To qualify for these loans, the total purchase and renovation price must not exceed FHA loan limits, which vary by state. All repairs and upgrades must be FHA-approved, and lenders must also abide by a specific appraisal process and work with pre-qualified consultants and contractors. Make sure you work with an FHA-approved lender that has extensive experience with this loan type specifically.

Minimum credit score required: 500 or higher.

Average rates: Rates vary, but average rates range from 2.5% to 3.5%

  • For older, damaged properties
  • Low 3.5% down payment
  • Fixed or adjustable rates
  • Variable or adjustable low interest rates
  • Federally insured
  • No income limit
  • Renovations will increase the home’s value quickly
  • Can be combined with an FHA Title 1 loan
  • Allows eligible cosigner
  • Requires collateral
  • 3.5% down payment is not available for credit scores lower than 500
  • FHA approval needed for the entire process
  • Has origination & closing fees
  • Repairs must be for your primary residence
  • There are maximum loan limits that vary by state
  • Investment and commercial properties are not eligible
  • Luxury upgrades like swimming pools are not eligible
  • No DIY allowed

FHA Title 1 Property Improvement Loan – Best for homeowners with poor credit and low equity

An FHA Title 1 Property Improvement Loan helps homeowners finance renovations even if they don’t meet the credit and equity requirements of private lenders. The mortgage is insured by the FHA, which means that the government pays up to 90% of the loan if the borrower is unable to repay it.

Loans with an FHA guarantee protect lenders against potential loss and ease qualification requirements for the borrower. Instead of looking solely at traditional metrics, lenders also evaluate your income and verify your employment. The maximum loan amount is $60,000, and loan terms are capped at 20 years.

While a Title 1 loan must be used for home upgrades, FHA restrictions are a bit more flexible. As long as the funds are used for permanent repairs that improve the use and liveability of the property, you’re good to go – you can even use the money to purchase certain appliances, or renovate non-residential structures, mobile and manufactured homes. Unlike a 203(k) Rehab Loan, you may DIY or hire contractors at your discretion.

To qualify:

  • You must own the property title or have a long-term lease
  • You must be able to make monthly payments
  • Your debt-to-income ratio must be 43% or less
  • The home must be finished and occupied for at least 90 days if it’s newly built

Minimum credit score required: none set by the HUD, but this may vary by lenders

Average rates: Rates vary, but average rates range from 2.6% to 3.5%

  • Government-backed
  • No home equity required
  • Low, fixed interest rates
  • Fixed monthly payments
  • No prepayment penalties
  • No collateral for loans under $7,500
  • Can be combined with 203(k) loan
  • Allows eligible cosigner
  • Requires FHA-approved lender
  • Requires FHA-approved appraisal
  • Loan amounts over $7,500 require collateral
  • Maximum loan limits
  • Origination and closing fees
  • Repairs must be pre-approved
  • Excludes temporary repairs or luxury upgrades, like swimming pools

Cash-out refinance – Best for when mortgage rates are low

A cash-out refinance pays off your first mortgage and replaces it with a new, larger loan that results in a lump-sum cash amount for discretionary use. The new loan may have different terms, such as a different interest rate or length. Cash-out refis can be both fixed- or adjustable-rate.

Lenders generally allow borrowers to access around 80% of the home’s value, meaning they must leave about 20% equity in the home. For example, say your home is worth $300,000, and you still owe $200,000 on your current mortgage. You have $100,000 in equity, but most lenders won’t let you pocket that full $100,000 in your cash-out refinance.

Eighty percent of your home’s value, in this case, is $240,000. That’s the maximum loan to value ratio (LTV) for your new loan. When you refinance for that $240,000, you’ll get to keep the $40,000 as cash.

Since a cash-out refinance is a new mortgage, this option makes the most sense if the new loan offers better interest rates and terms, and if you’re financing improvements that increase your home’s value and equity.

A mortgage refinance calculator can help crunch the numbers for you. If a cash-out refinance is a net positive, start researching and compare loan rates from our best mortgage refinance companies of 2021.

Minimum credit score required: 620 or higher

Average rates: Rates vary, but average rates range from 3.3% to 4.3%

  • Fixed-interest rates and monthly payments
  • Lump-sum cash amount
  • Unrestricted use
  • Can finance the renovation of a rental property
  • Increases total amount of debt
  • Requires underwriting and appraisal
  • Has originating and closing costs
  • Requires a healthy DTI ratio
  • Requires a strong credit score
  • Requires enough equity

Home equity loans (HEL) – Best for homeowners with stable income and high equity

Home equity loans are installment loans repaid over 5-30 year terms via fixed monthly payments. You’re essentially taking out a second mortgage, borrowing against your home equity to secure funding. This money may be spent on costly expenses like home improvements, college, debt consolidation, or long-term medical care.

A home equity loan amount cannot exceed 85% of your home equity, so it’s a good idea to have a budget in place for your renovation before considering this option. Also, consider how much you’ll pay in closing costs, origination and appraisal fees.

Home equity loans are risky. While they can fund important life expenses, they have high interest compared to first mortgages. The best home equity loans favor homeowners who can comfortably afford long-term debt and have built enough equity. Using them to get out of economic hardship is generally not advisable, as failure to repay puts your home at risk.

Minimum credit score required: 660 or higher

Average rates: Rates vary, but average rates range from 3.2% to 7.7%

  • Fixed rates and monthly payments
  • Lower rates than personal loans and credit cards
  • Lump-sum cash amount
  • Unrestricted use
  • Interest may be tax-deductible
  • Foreclosure risk
  • Requires enough equity
  • Requires a stable, reliable income
  • Upfront application and appraisal costs
  • Origination fees
  • Requires strong credit score

Home equity line of credit (HELOC) – Best for homeowners with high equity who need flexibility

A home equity line of credit, commonly called a HELOC, borrows against home equity, just like a home equity loan. The difference is that a HELOC awards a revolving credit line backed by your home equity instead of a lump sum payment.

This lump sum awards you more flexibility, especially if the renovations don’t have a set price tag. You can withdraw money as needed up to a certain amount, but it’s common for lenders to set minimums and charge withdrawal fees.

HELOC interest rates will depend on your credit history, loan-to-value ratio and loan amount. Cosigners are one way to get a better rate but won’t have any ownership rights to the property.

Home equity lines of credit have an initial “draw period” (10 years in most cases), during which you can withdraw money. Repayment plans within this period vary. Some lenders allow you to start paying the principal plus interest in monthly installments, or interest first, and principal at the end. What matters most is that you must be ready to repay any outstanding debt in full after the draw period expires, whether by refinancing or some other means. Failure to do so risks foreclosure.

A HELOC’s flexibility can work against you if you use it irresponsibly and borrow beyond your means. Before settling on a HELOC, explore and compare every loan option and gather information from trustworthy sources. The Federal Reserve Board’s guide to HELOCs is a great starting point.

Minimum credit score required: 660 or higher

Average rates: Rates vary, but average rates range from 1.9% to 6.8%

  • APR rates are lower than most credit cards
  • Revolving line of credit to be used at your discretion
  • Offers flexibility on a renovation budget
  • Lenders may waive closing costs
  • Interest may be tax-deductible
  • Foreclosure risk
  • Requires enough equity
  • Requires strong credit
  • Higher rates than first mortgages
  • Variable interest rates
  • Added appraisal and closing costs
  • Lenders may freeze or reduce credit line
  • Rental properties do not qualify

Personal loan – Best unsecured option for good to excellent credit scores

Personal loans can be convenient for homeowners with good to excellent credit scores who need fast financing and don’t want to put their homes up as collateral.

The best personal loans are available from several private lenders and credit unions. The application process can be much faster than for the other financial instruments on this list, especially if you work with an online lender like Lightstream.

Many personal loan servicers also guarantee no prepayment penalties and direct funding to your bank account by the next business day. Ranging between 1 to 5 years, monthly repayment plans tend to be significantly shorter than other financing options.

Creditworthiness is weighed heavily during the application process—lenders offer the best rates to borrowers with excellent credit. To determine their risk, loan providers look at your credit history and use either your FICO or VantageScore.

If your credit score needs work, you can find out how to repair your credit or look into our list of best credit repair companies. Keep in mind that even the best personal loan interest rates may still be higher than for secured loan options since the lack of collateral or government insurance poses a higher risk for the lender.

Minimum credit score required: 620 or higher

Average interest rates: Rates vary, but average rates range from 3% to 36%

  • No foreclosure risk
  • No home equity requirements
  • Lump-sum cash amount for discretionary use
  • Fast funding
  • Fixed or variable interest rates
  • Lenders may waive origination fees
  • Higher loan rates
  • Requires good to excellent credit
  • Short repayment term
  • No federal loan benefits or protections
  • Interests are not tax-deductible

Credit cards – Best for affordable, small-scale projects

Consider a credit card for minimal upgrades you can afford to pay in full but would prefer to finance over a few months, such as a paint job or a new appliance. Many credit cards offer an introductory 0% APR period of 12 months, meaning you won’t pay any interest on the outstanding balance for a full year. You can also take advantage of any cashback rewards for home improvement-related purchases.

Best practices include never charging more than what you can afford and keeping your credit utilization ratio below 30%. Credit card APR rates are some of the highest (around 16% to 24%), and outstanding debt can quickly snowball and plummet your creditworthiness. For large-scale home renovations or long-term projects, it’s best to consider other loan options.

Minimum credit score: varies per credit card type and company

Average interest rate: Rates vary, but average rates range from 16% to 24%

  • No collateral needed
  • 0% APR introductory period
  • Unrestricted use
  • You can use the credit line as needed
  • Possible cashback rewards
  • Very high APR rates
  • High debt can become unmanageable
  • Raises credit utilization ratio
  • Best for simple, affordable repairs
  • Interests are not tax-deductible

How Do You Choose The Right Home Improvement Loan?

To choose the best home improvement loan, examine your financial situation – your credit report, credit score, credit history, debt-to-income ratio, mortgage equity, and income. Determine the cost of your home improvement project, what funding options you qualify for, and compare lenders to find the lowest rates. Are you willing to put your home as collateral, or do you prefer an unsecured personal loan? Do you qualify for any federal loan programs? Our guide on how to get a home improvement loan can help you get started on your loan application.

Home Improvement Loans FAQ

How long are home improvement loans?

The term length of your home improvement loan depends on the type of loan you choose. Personal loan terms range from 12 to 60 months. Loans backed by your mortgage tend to have longer repayment periods. A home equity loan or home equity line of credit may last up to 20 years, and FHA caps its property improvement options at 20 years.

Where to get a home improvement loan?

You can get home improvement loans from your mortgage servicer, personal loan providers, or FHA-approved lenders. If you already own a home, consult with your bank and compare their offers with types of loans to get the best terms and lowest rates.

Can you use a home improvement loan for anything?

Personal loans meant for home improvement can still be used for other expenses, should the need arise. The same applies to funds acquired through a cash-out refinance, home equity line of credit, or home equity loan.

Home improvement loans acquired through federal loan programs are stricter. After meeting eligibility requirements, pre-qualified contractors must make all repairs, and funds must be used for home improvements, as defined and approved by the lender and FHA.

Should I take out a loan for home improvement?

Everyone could pay for home improvements in cash in an ideal world, but repairs are often so expensive that a loan is the only option. If repairs are necessary and you plan on living there for many years, then yes, consider taking out a home improvement loan.

Summary of Money’s Guide to Home Improvement Loans

Home improvement loans are financing options for homeowners who want to upgrade their homes and can afford the long-term debt. Homeowners with enough equity may be able to finance expensive repairs with a cash-out refinance, home equity loan, or home equity line of credit. Qualifying borrowers who do not meet the credit or equity requirements should consider more affordable FHA loans tailored for home renovations, like a 203(k) Rehab Loan or Title I Property Improvement loan.

Personal loans charge higher interest rates but may offer a more flexible alternative if you have good to excellent credit. An advantage is that there are no collateral requirements and no use restrictions. Examine your financial information closely to determine which home improvement financing option fits best.

Ideally, a home improvement plan should pay for itself in the long run, increasing the value of your home and contributing to your overall quality of life.

 

 

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