Finance

5 Most Common Types of Home Improvement Loans

March 12, 2022

From building a new deck to renovating your bathroom, a home improvement project can be expensive—very expensive. In fact, some kitchen renovations cost upwards of $30,000.

Fortunately, most people don’t have to incur those costs out-of-pocket. That’s because there are several types of home improvement loans at your disposal.

However, with choice comes decision. Which borrowing option will help you upgrade your home without adding a financial burden?

In this article, we’ll describe the five most common types of home improvement loans. We’ll break down each loan’s pros and cons so that you can make your choice with full confidence.

1. Personal Loans

A personal loan is exactly what the name suggests—loans that you can take out for any personal use, whether it’s getting a hot tub or paying off debt.

The main types of personal loans include:

Secured loans – Secured personal loans are personal loans “secured” (backed up) by collateral. This collateral might be your house, car, or other property. If you default on a secured loan, your lender can seize the asset used as collateral. Secured loans can take longer to process, but typically carry a lower interest rate than an unsecured loan since they pose less risk for the lender.
Unsecured loans – The opposite of secured loans, an unsecured personal loan is a loan that is not backed up by collateral. As a result, lenders take your financial health into account by considering your credit history and debt-to-income ratio. Your financial history will determine the loan amount and the interest rate. While unsecured loans are generally quick to process, they can have a higher interest rate.

If your credit is good, you can apply for most loans without using your home as collateral. And because they are personal, their use isn’t restricted—feel free to buy that hot tub and pay off some high-interest credit. If you have bad credit, we have you covered. Read on to learn more about how to navigate home improvement loans with bad credit.

Pros and Cons

Using personal loans for a home improvement project comes with a few advantages and disadvantages.

One of the biggest advantages is processing speed. Personal loans are often available quickly, making them perfect for emergency home repair.

There are other advantages:

An unsecured loan won’t use your home as collateral
These loans are fairly easy to apply for

However, there are a few disadvantages including:

Higher interest rate
Credit is taken into account
Interest cannot be deducted from your taxes

2. Home Equity Loans

A type of secured loan, a home equity loan uses your home as collateral. This means that if you default on your loan, your lender can seize your home. Home equity loans are also called “second mortgage”

Before diving into the details of using a home equity loan for a remodel or improvements, let’s first define home equity.

In short, home equity refers to the amount of money you’ve invested into your home. To calculate your home equity, subtract all loans on your house (mortgage balance, second liens, etc) from your home’s current market value. The difference is your equity.

For example, suppose your home’s market value is $750,000 and your mortgage balance is $400,000. Your home equity is thus $350,000. This number is then used to gauge how much you can borrow. Most lenders will lend you up to 90% of your home equity. For example, if your home is $350,000, you can typically expect to borrow up to $315,000.

Pros and Cons

Home equity loans present an attractive option for some borrowers. In addition to fixed interest rates, home equity loans have the following advantages:

Interest is tax-deductible
Loan terms tend to be longer, resulting in a lower monthly payment
Interest rate is not primarily based on credit

Given these characteristics, home equity loans might seem like an ideal way to finance major and expensive home projects.

That said, here are a few disadvantages:

Your home is used as collateral
Your debt-to-income ratio can increase dramatically
You’ll pay closing costs

However, it’s important to remember that defaulting on this loan can result in your lender seizing your home.

3. Cash-Out Refinancing

Cash-out refinancing for home improvements involves borrowing from your home equity to finance home improvement projects and/or other needs.

Like home equity loans, cash-out refinancing uses your equity to determine how much you can borrow. However, unlike home equity loans, a home equity loan replaces your current mortgage rather than adding a second mortgage.

For example, suppose your mortgage is $350,000, your equity is $200,000, and you need $40,000 for an extensive home makeover. Cash-out financing allows you to take out a new loan for $390,000 (plus closing costs).

With that money, you’ll pay off your current mortgage and receive $40,000 in cash
You now have $160,000 in equity.

Keep in mind that you’ll pay closing costs (just as you did when you took out your initial mortgage). If you’re not prepared to pay those in cash, you might need to roll them into your new mortgage loan. In that case, the loan will be slightly larger, your home equity will be lower, and you’ll pay interest on a higher total amount.

Pros and Cons

Because cash-out refinancing keeps your finances relatively simple, replacing one mortgage with another, it can be an attractive option for people who have high home equity and low cash. How attractive all depends on the specifics of the loan term and your financial situation.

Potential pros of cash-out financing include:

Deductible interest
Ability to borrow large amounts

However, while cash-out financing may be good for some people, it may not be good for others. Drawbacks to cash-out financing include:

A higher total loan amount
Home foreclosure if your default
The need to pay for mortgage insurance
A new loan term, keeping you in debt for longer

Also, take a careful look at available interest rates. If market conditions have improved and you’re now eligible for a much lower interest rate, a refinance could actually lower your monthly payments.

However, the reverse is also true. If your financial situation has changed, you may only be eligible for high-interest loans that will result in a higher total payment over your mortgage’s lifetime.

4. A Home Equity Alternative

Using your home equity to your advantage is one of the major perks of homeownership.

But sometimes, accessing your investment comes with a ton of headache and hassle. What’s more, you may need your money quickly to finance a major home renovation.

You could take out a home equity loan or new mortgage. Or, you could follow other American homeowners on the path towards a more sensible financial solution: using a sale-leaseback program as a home equity loan alternative.

Benefits of Sale-Leasebacks

A sale-leaseback helps to eliminate the need for a loan, converting your home equity to cash without all of the restrictions accompanying traditional loans.

Through a sale-leaseback, you sell your home to convert your equity to cash that you can use for home repairs or paying down accumulated debts. However, instead of moving out, you get to stay in the home as a renter.

5. FHA 203(k) Rehab Loan

In a perfect world, every home you buy would be in tip-top shape. However, many homes need repairs—often significant ones. The problem is that when added to the cost of the house, these repairs can be too expensive for most potential homebuyers to afford.

Enter: FHA 203(k) Rehab Loans.

Offered through the Federal Housing Administration, FHA 203(k) Rehab Loans bundle the cost of the home and the cost of renovations into one loan. This makes financing home renovations and building home equity easy.

How It Works

To understand how this loan type works, it’s helpful to break down the loan into its subsets:

Full 203(k) – The less popular of the two FHA 203(k) loans, the full 203(k) loan has no limit as long as your repairs don’t exceed your region’s loan amount. The loan allows for all types of repairs, including structural.
Streamlined 203(k) – Unlike the full 203(k), the streamlined FHA 203k loan doesn’t allow total structural repair or changes, nor is there an unlimited repair limit. Instead, the streamlined 203(k) is capped at $35,000.

Because most homeowners aren’t looking at structural repairs, the streamlined FHA 203k loan option can meet any homeowners’ needs. And for first-time buyers with poor credit, FHA loans for bad credit is a viable option for your home improvement needs.

Pros and Cons

In addition to the convenience of bundling a repair loan with a mortgage, the 203(k) comes with many benefits. These benefits include:

Easy way to build equity
Potential increased tax deduction
Reduced criteria for income and credit score
Low down payment
Low closing costs

However, there are a few disadvantages. First, you can only take out this loan type when buying a new home or refinancing your current home. That means they’re not an option for emergency repairs or desired upgrades (unless you’re willing to refinance).

Other disadvantages include:

Limits as to what you can repair (at least with streamlined 203(k))
A repair limit of $35,000
More paperwork than other home improvement loans
Extra costs (inspection fees, title update fees, etc.)
Not for smaller projects

The Best Solution for Homeowners

If you’ve ever improved your home, you know how expensive it can be. Even minor renovations can quickly add up. Although there are many home remodel financing options, they often come with high-interest rates, narrow eligibility criteria, and the stress of additional debt (not to mention interest payments).

However, the best option for you may not be a traditional loan at all. Instead, it may be the sale-leaseback, an alternative to home equity loans.

Whether you need bathroom or garage financing for a remodel, a sale-leaseback can make it easy for you to get the cash you need.

Key Takeaways

Home improvement can be expensive. Fortunately, you don’t have to tackle the costs yourself. When consider the best types of home improvement loans for you, be sure to look at loan-alternatives like sale-leasebacks as well. When in doubt, consult a financial advisor to help you ensure you’re making the best choice for your family and your financial health.

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