Home improvement loan types
Maintaining your home isn’t exactly cheap. But with the right financing, home improvements can be made more affordable. A home improvement loan is a financing option that you can use for remodeling, renovating, or repairing your home. Potential projects include:
- Repairing your roof
- Upgrading your HVAC system
- Building a deck
- Upgrading your kitchen or bathroom
- Installing new countertops
- Updating an older property
Some home improvements can add value to your home, so if you plan to sell your home in the future, home improvement loans can bring a strong ROI.
There’s more than one type of home improvement loan. Here’s an overview of the most common types of loans for home improvement.
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With a home equity loan, you’ll use the equity in your home as collateral for another loan. That’s why these loan programs are commonly known as a “second mortgage.”
To determine the equity in your home, simply take the current market value of your property and subtract the remainder of your mortgage. So if your home is valued at $400,000 and you owe $100,000 on your mortgage, you have $300,000 worth of equity.
Most lenders will expect you to have at least 20% equity in your home before approving a home equity loan. And unlike an unsecured personal loan, you’ll use your own home as collateral. This means that if you fail to repay the loan for any reason, you risk losing your house.
Home equity loans provide access to large amounts of cash, but be wary of high interest rates. And if you’re still paying your current mortgage, a home equity loan will add to your monthly expenses.
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Rather than a lump-sum payment, a home equity line of credit (HELOC) will provide a flexible financing option not unlike a consumer credit card. During the initial “draw” period, you can access the equity in your home on an as-needed basis, up to a certain credit limit. As long as you repay the balance, you can continue using your HELOC as a flexible source of funding.
A HELOC can be a great option for homeowners who don’t have a set budget and simply need a line of credit to fund their projects as they unfold. And unlike a home equity loan, you’ll pay interest only on the money you actually spend.
Just keep an eye on your spending, otherwise you could rack up a higher balance than you anticipated. And just like a home equity loan, a HELOC will use your house as collateral, which means you could lose your home if you can’t make your repayments.
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A cash-out refinance (sometimes shortened to a “cash-out refi”) offers two distinct advantages.
First, you’ll be refinancing your existing mortgage, which means you’ll completely replace your current home loan with a brand-new one. Ideally, you’ll have an opportunity to secure a lower interest rate or even shorten your loan term to get out of debt faster.
Second, in a cash-out refinance, you’ll take out a loan for more than you need for your existing mortgage. The excess can then be used for personal expenses, including home improvements. For example, if you currently owe $150,000 on your mortgage but anticipate that you’ll need $50,000 for home improvements, you can get a loan for $200,000.
Homeowners will especially love the fact that a cash-out refinance won’t add a second loan payment to their monthly expenses since they’re simply replacing their current mortgage. Additionally, if interest rates are in your favor, you may even save money on your house. And if you’re using the funds to fix your house, you may qualify for an income tax deduction.
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An FHA 203k loan (also known as an FHA rehabilitation loan), allows homeowners to bundle the cost of their home and home improvements in a single loan. So you can use an FHA 203k loan to purchase a “fixer-upper,” or you can use an FHA 203k loan to remodel or repair your existing home.
There are two types of FHA 203k loans:
- Limited: For loans up to $35,000
- Standard: For loans larger than $35,000
Limited 203k loans are generally easier to obtain, while standard 203k loans require a visit from a consultant with the Department of Housing and Urban Development (HUD), the government entity that oversees the FHA, which insures these loans.
These loans are restricted to residential properties, not commercial properties or homes you intend to flip. However, the eligibility requirements are typically much lower than conventional loans, providing financing to those with credit scores as low as 500.
Just be aware that extensive projects require the oversight of your HUD consultant and must be completed in a timely manner (six months, in most cases). And while it’s easier to qualify for these loans, borrowers will have to pay FHA mortgage insurance premiums, which can add to monthly payments.
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Backed by the U.S. Department of Agriculture, USDA renovation loans also allow homebuyers to bundle their mortgage and renovation loans in a single financial product.
- To qualify, residents must meet the following criteria:
- The home must be located in a rural location
- The home must be the borrower’s primary residence
- Borrowers must meet income limits for the area
- Borrowers need a strong credit score (typically 620 or better)
- Borrowers must be unable to obtain affordable credit elsewhere
USDA renovation loans come in two types. The Limited USDA Renovation loan covers repairs up to $35,000. The Full USDA Renovation loan has no limits but requires oversight from a HUD consultant.
There are also some minor restrictions on the types of home improvements you can make with a USDA renovation loan. While structural repairs are covered entirely, you can’t use this loan program for in-ground swimming pools or any improvements that allow you to generate money from your property.
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USDA repair and rehabilitation loans fall under the USDA Section 504 Home Repair program. These loans are aimed at very low-income homeowners from rural areas, allowing them to repair or improve their existing homes.
To qualify, homeowners must fall below 50% of the median household income for the area. The program also features grants aimed at homeowners aged 62 and over, providing funds to remove health and safety hazards in the home.
Conventional renovation loans
Conventional renovation loans (or simply “conventional rehab loans”) are mortgage products that let homebuyers fund the cost of a home and its renovations in a single loan. This can be a great option for homebuyers who are considering a fixer-upper property to save on their initial purchase price.
Some conventional rehab loans have strict eligibility criteria, including:
- A strong credit history
- A debt-to-income ratio of 45% or less
- A down payment of 5% to 20%
Of course, these requirements vary by lender, with some lenders offering greater flexibility on things like down payment or credit score requirements. However, the better your financial situation, the more you can count on favorable rates and terms. And unlike other options, you won’t have to worry about taking on a second mortgage to pay for home improvements.
Additionally, there are several different options to consider with conventional rehab loans.
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Fannie Mae’s HomeStyle renovation loan offers a basic rehabilitation loan for new homebuyers. You can use a HomeStyle loan to cover a range of home improvements, all through a single mortgage.
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Fannie Mae’s HomeStyle Energy loan allows homebuyers to:
- Make upgrades that improve the home’s energy efficiency
- Make upgrades that improve protection against natural disaster
- Pay off energy-related debt
HomeStyle Energy loans can fund up to 15% of the “as completed” property value for home improvement projects.
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GreenCHOICE is Freddie Mac’s version of Fannie Mae’s HomeStyle Energy. Borrowers can use this program to make energy-efficient improvements to the home, such as installing better insulation, upgrading HVAC systems, and installing renewable energy systems.
How to get a home improvement loan
When you’re ready to fund your next home improvement project, you’ll need to secure a loan. Here’s how to get a home improvement loan and what you can expect from the financing process.
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Set a goal
First, set a goal. This will help you determine what kind of financing you need and how much. If you’re unsure, a HELOC may be able to provide you with flexible funding. In other cases, cash-out refinancing or personal loans offer lump sums for larger projects.
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Determine your loan type
Which renovation loan type is right for you? Use the above guide to determine which home improvement loan matches your needs and which might be ideal for your budget. For instance, if you’re purchasing a fixer-upper, a conventional renovation loan might be a way to secure financing without taking on secondary debt to get a home improvement loan.
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Compare lenders
Always compare lenders to find the best mortgage interest rates and repayment terms. Compare at least three lenders to ensure you’re getting the best value, and watch out for any added costs such as origination fees.
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Gather your documents
Most lenders expect to see things like bank statements, tax returns, and other financial documents to assess your creditworthiness. Having these documents prepared ahead of time can streamline the approval process.
Many lenders will also consider non-traditional forms of credit, so bring as many financial documents as you can to the process of securing a loan.
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Apply for a loan
You’re now ready to apply for a loan. You’ll use the unique application process for each lender and/or loan type. If you apply for multiple loans, try to apply within the same 30-day period. Multiple applications during this period don’t affect your credit score as severely as spreading your applications out over time.
Securing the right financing
While home improvement is no easy subject, to get a home improvement loan can be straightforward as long as you understand the process.
Even if you don’t qualify for a traditional loan, many lenders will consider alternative sources of credit to connect you with the right loan. By finding the right lenders, you can transform your current home into the home of your dreams.
