Choosing the right home improvement loan
Homeowners who choose the wrong home improvement loan can throw away a pile of cash. But there’s no single right or wrong choice.
Which will suit you best will depend on how much you want to borrow, how good your credit is and how much “equity” (the amount by which your home’s market value exceeds your mortgage balance) you have.
To equip yourself with the information you need to make an informed choice, keep reading.
1. Credit card
Average credit card rates at the time of writing are 16.7 percent. So you don’t want to borrow much, or for long, with plastic. Still, there are three ways in which smart people use their cards for home improvements:
- When they want to borrow just hundreds and can easily pay that down quickly
- When they want to earn rewards, and will pay the balance in full
- When they get a card with a zero-percent APR on purchases for up to 21 months — providing they can pay the debt off during that period
Cards often involve the least hassle: You’re using an existing line of credit. And, even if you apply for a new card, the process is quick and free. Just avoid borrowing more than you can pay back quickly.
2. Personal loan
These typically have lower interest rates than credit cards, and with fixed interest rates and payments, they make budgeting easier. But those are still higher than the other types of loans explored below. So personal loans may be best if you’re borrowing smallish amounts, perhaps $1,000 to $5,000.
If you have a rewards credit card, you might want to put the improvements on it, then repay it with a personal loan at a better rate.
Again, you’re likely to get a decision on your application quickly and with little hassle. Meanwhile, the set-up costs are generally low and often free.
If you want to borrow larger sums, the options below almost always come with lower rates. However, expect significant set-up costs and more admin with them. And they are also “secured,” meaning you could face foreclosure if you fail to keep up payments.
3. Home equity loan
You borrow a lump sum and pay it back in equal installments over an agreed term. And you will probably get a fixed interest rate. So this is a simple, straightforward and highly predictable loan.
Because second mortgages are riskier for mortgage lenders than first mortgages, you’ll pay a higher interest rate. But because the loan is secured by your home, it’s lower than just about any other financing.
It’s a second mortgage, so expect to have to provide plenty of documentation before closing. And closing costs can be significant, though not usually as high as on a first mortgage. They can often be rolled up into the loan.
4. Home equity line of credit (HELOC)
A HELOC shares characteristics with both a home equity loan and a credit card. It’s still a second mortgage. However, the closing costs are lower (even zero, in some cases) and they tend to process faster.
As with plastic, you get a credit limit, and you can borrow and repay up to that amount as often as you wish. Better yet, you pay interest only on your outstanding balance.
This flexibility can be very attractive for multi-phase home improvement projects, where money needs to be invested over longer periods.
HELOCs can be harder on budgeting, because they almost always come with variable interest rates. In addition, each HELOC has two phases — a “drawing” phase, in which you can use and reuse your credit as much as you like, and a “repayment” phase, when you can no longer borrow, and must repay the balance over the remaining years of the loan.
Some HELOCs let you fix your interest rate once you enter the repayment period. They are called “convertible” HELOCs. Just make sure you fully understand how your line of credit works.
5. Mortgage refinance
A home equity loan or HELOC gives you a second mortgage. But you might prefer to refinance your existing first mortgage instead.
You’ll then have just one loan. And you’ll likely get a slightly better rate than second mortgages typically offer. But you’ll usually face the full mortgage application process.
And closing costs may be higher than with other sorts of loans. Still, you may well be able to roll up those costs within the loan.
5a. Cash-out refinancing
If you have worthwhile equity in your home, you may be able to access some of it using a cash-out refinancing. This sees you get in cash the sum by which you increase your mortgage balance, less costs. And you can spend that on home improvements —or anything else you want.
Obviously, this is especially attractive if your current mortgage has an interest rate that’s higher than the new one. In that case, your monthly payments might hardly move.
But it’s often a bad idea to refinance to a higher rate than your existing one. You might be better off using a home equity loan or HELOC. That way, only part of your borrowing is at a higher rate. Use a mortgage calculator to model your options.
5b. FHA 203k loan
These 203k loans from the Federal Housing Administration are loaded with pros and cons. Maybe the biggest pro is that you can borrow against your future home equity, because the loan-to-value ratio is based on the improved value of the property.
Another advantage is that you stand a good chance of getting approved, even if your credit score is unimpressive.
But perhaps the biggest drawback is that you’ll be on the hook for mortgage insurance premiums (MIP) premiums until you sell your home or refinance again.
5c. Streamline 203k loan
If your budget (including a 15-percent contingency) is $35,000 or less, you may be eligible for a streamlined version of the FHA 203k loan. However, you need to be able to stay in your home throughout your project.
What’s the upside? You get an easier process, including fewer demands for paperwork, and straightforward payments to your contractor.
Fannie Mae’s HomeStyle® Renovation loan is a bit like the FHA’s 203k loan. But it’s often cheaper and easier to close. And it can be more flexible. You can even use one for your vacation home or investment property.
The downside? You’ll likely need a better credit score than the FHA requires.
6. Other sorts of borrowing
For most, the above are probably the most sensible choices for home improvement loans. But, in exceptional circumstances, it might be worth considering others.
You might, for example, borrow from your 401(k) retirement program. Or, if you’re 62 years or older, you could think about a reverse mortgage, aka home equity conversion mortgage (HECM).
However, you must consider the strategic financial implications of these methods. Use one only if you’ve taken financial advice from a trusted and experienced professional.