Home improvement loans: Which type is best for you?

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In a Nutshell

If you want to take out a loan to fund improvements to your home, there are several financing options available, including home equity loans, home equity lines of credit and personal loans. Take the time to understand these three choices so that you can make the best decision for you.

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Ready for home renovations? With the cost of home improvement projects looming, you may be thinking about financing using a home improvement loan.

If you don’t have the cash on hand to pay for home repairs or a major improvement like a kitchen renovation, you’ll need to find a way to finance your project. A home improvement loan might be right for you. While there’s no specific lending product called a “home improvement loan,” there are three lending options you’ll likely hear about when it comes to funding home improvements: home equity loans, home equity lines of credit and personal loans.

We’ll compare the three and discuss what might be best for your situation.

Home equity loans

A home equity loan is a secured loan for a fixed amount of money. A secured loan means that you’ve agreed to use a property — in this case, your home — as collateral.

How a home equity loan works

When you apply for a home equity loan, the lender will determine how much you qualify to borrow based on several factors, including how much equity you have in your home. Your equity is figured by subtracting how much you still owe on your mortgage from the market value of your home. You’re typically limited to borrowing an amount equal to 85% or less of the equity in your home.

The lender can also consider factors like your income, debt and credit history before deciding exactly how much you can borrow.

Here’s an example of how that can break down.

  • Say your home’s been appraised at $200,000 (its market value) and you owe $140,000 on your mortgage.
  • The difference is the equity you have in your home, in this case $60,000.
  • If 85% of your equity is the most you can borrow, you could potentially be approved for up to $51,000 ($60,000 x .85) with a home equity loan.

Similar to a mortgage, with a home equity loan you’ll receive a lump sum of money at one time and you’ll be charged interest over a fixed repayment period (typically 10 to 15 years).

Other things to consider

  • Fees — Just like when you took out your first mortgage, you’ll be required to pay fees for a home equity loan. These fees can include an application fee, appraisal fee, broker fees and others.
  • Home sale — If you sell your home while you have a home equity loan outstanding, your loan might become due, depending on the terms (another reason why it’s important to read your loan’s terms carefully). It’s known as your “second” mortgage, because this debt will be repaid after your original mortgage is paid off during a home sale.
  • Property risk — If you’re unable to make the monthly payments, the lender might be able to force you to sell the home.

Is it right for me?

Taking a lump sum all at once can be helpful if you need a set amount of money for a specific purpose — like remodeling your home — making a home equity loan useful.

Home equity lines of credit

A home equity line of credit, or HELOC, is another type of secured home improvement loan that uses your home as collateral. While it’s similar to a home equity loan, there’s a big difference in how the money is disbursed.

You’ll be approved for a specific amount of credit, but you won’t receive the money in a lump sum like you would with a home equity loan. Instead, you’ll be able to borrow money up to your set limit during a draw period (the time frame during which you can withdraw funds).

How a HELOC works

Just as with a home equity loan, a lender will consider your financial details and may approve a HELOC of up to 85% of your equity in your home.

During the draw period, you’ll be able to withdraw money up to your approved credit limit, typically by using a check or a special credit card.

Depending on the terms of your HELOC, you’ll typically either need to pay back the entire loan immediately after the draw period, or you’ll enter into a repayment period where you’ll make regular payments for a set amount of time.

Your draw period can last a long time. For example, both Wells Fargo and Bank of America offer draw periods that last for 10 years.

If during the draw period your home value decreases significantly, or your financial circumstances change, your lender may be able to decrease the amount of credit available or freeze your ability to draw more money.

Also, HELOCs often come with variable interest rates, meaning your interest rate and monthly loan payment could change during the loan (this is true for home equity loans with variable rates, too).

Other things to consider

  • Fees — You’ll be charged fees that are very similar to what you paid when you got your original mortgage. This can include appraisal fees, application fees, closing costs and attorney fees. Additionally, you may be charged ongoing maintenance fees, annual membership fees and transaction fees each time you make a loan withdrawal. These fees can add up, so pay attention to everything that you’re paying.
  • Balloon payment — If your HELOC doesn’t have a specific repayment period at the end of the draw period, you might be required to pay off the entire loan as a “balloon payment” once the draw period ends. But it depends on what’s laid out in your agreement. Be sure to read through your HELOC’s terms carefully.
  • Home sale — If you sell your home while you still have a balance on your line of credit, most lenders require you to pay back what you owe at the same time.
  • Restrictions on withdrawals — A HELOC is set up so you can withdraw money when you need it, but lenders sometimes include extra restrictions that you need to follow. This can include a minimum amount required for each withdrawal or a requirement that you keep a minimum amount outstanding on the loan.

Is it right for me?

A HELOC is helpful if you have several projects you want to work on over a period of time and don’t want to have to go back to a lender each time.

Just make sure you can stomach any potential rate changes or balloon payments that might apply if you go this route. And remember, read your terms thoroughly so that you understand the fees and any restrictions involved.

Personal loans

In contrast to a home equity loan or a HELOC, a personal loan may be unsecured.

With an unsecured personal loan, there is no property used as collateral. Since the lender doesn’t have the option of foreclosing on your home if you don’t repay the loan, it’s considered riskier for the lender. Because of this, lenders usually charge a higher interest rate on unsecured loans.

How a personal loan works

When you apply for a personal loan, the lender’s decision about whether to approve your loan and how much to lend to you isn’t tied directly to the value of your home. Instead, the lender will make its decision by looking at different things, like your income, debt, credit reports, how you’ll use the money and other factors.

The approval process for a personal loan can be quick — it can even be completed as quickly as a week or less. You’ll begin making monthly loan payments soon after receiving your money.

Other things to consider

  • Term length — The term length for personal loans can be shorter than for home equity loans or HELOCs. It’s common to see a term length from three to seven years.
  • Fees — You typically won’t see as many fees for a personal loan as you will for a home equity loan or HELOC, but you still need to be aware of what the lender is charging. Watch out for loan origination fees and prepayment penalties especially.

Is it right for me?

A personal loan may be your best choice if you have good credit but don’t have much equity in your home yet.

Or a personal loan may be preferable if you’re wary of putting your home up as collateral and don’t mind paying a higher interest rate.

Bottom line

When you’re considering a loan to help finance your home improvements, there isn’t a one-size-fits-all loan that works for every situation. Explore the loan options available to you to see which option best fits your needs.

About the author: Erica Gellerman is a personal finance writer with an MBA in marketing and strategy from Duke University. She’s also the founder of The Worth Project: a weekly money newsletter you actual… Read more.