Americans spend a lot of money on home improvements and repairs every year — more than $400 billion in 2019, according to the Harvard University’s Joint Center for Housing Studies.
And while the recession due to the pandemic means people are spending less on home improvements this year, renovating a home is still a great way to boost its value and make it a better place to live.
That’s especially relevant now that people are spending a lot more time indoors during the pandemic.
But the costs of those renovations can add up quickly.
If you’re wondering how to finance a home improvement project, know there are several options to choose from. Many home improvement projects are funded with a home equity loan or home equity line of credit (HELOC), but there is a third option: taking out a personal loan for home renovations.
Unlike a home equity loan or HELOC, a personal loan for home improvement does not require you to put up your home as collateral. The funds are disbursed up front in a lump sum. However, it will likely have a much higher interest rate than a home equity loan or HELOC, and generally a much shorter repayment period — anywhere from one to five years.
Personal loans are “always a little bit more risky,” says Carol Ann Reed, a real estate agent with Realty Group in Minnesota. “It’s always better to cover the cost of repairs and renovations with cash instead of borrowing,” Reed says. Sometimes, that may not be realistic for expensive home renovations or urgent repairs. Here’s what to know about funding home improvements with a personal personal loan—and some alternatives to consider, too.
Should You Get a Personal Loan For Home Improvements?
A home equity loan, HELOC, or cash-out refinance are better options to consider, says Dan Moralez, a mortgage officer and regional vice president with Northpointe Bank in Michigan.
“The problem with a personal loan is you’re generally going to pay a higher interest rate and you’re usually going to have an expedited repayment term because there’s no collateral,” says Moralez. “It’s probably the worst way to finance home improvements.”
So if you’re weighing the idea of getting a personal loan for home improvements, consider your priorities and overall financial situation. Look at how much equity you have in the home, analyze your credit health, consider what interest rates would likely be available to you given your credit score and overall financial picture, and compare secured versus unsecured borrowing.
Talk to multiple potential lenders, and keep in mind that a personal loan to finance your home improvement project makes the most sense in the following scenarios:
You Don’t Have Much Equity in the Home
If you haven’t built up a lot of equity in your home, a personal loan can be a way to finance a small to mid-sized home improvement project, like updating your kitchen appliances or replacing an outdated HVAC system.
Your Creditworthiness Is Stellar
Your credit and financial history plays a big role in whether a personal loan is the right fit for your next project. The higher your credit score, the lower your interest rate will be for a personal loan, all other factors being equal. There’s also a heavier emphasis on your income and debt-to-income ratio — your overall debt compared to your income — to qualify.
“A personal loan is a little bit more dicey as far as a bank is concerned. There are secured and unsecured personal loans, so you can secure it with some sort of collateral like your car, but that’s not as stable as your house,” Reed says.
Before you apply, pull your credit report online and check your credit score through your credit card issuer to see where you fall on the spectrum (both are free and only take a few minutes to do). If your credit score is in the mid to low-600s or lower, it’s worth looking at other financing options or saving up enough to pay for the renovations upfront.
“A good credit score is going to matter more with a personal loan,” Reed says. “If you have bad credit, wait until your credit is in a better position because you’ll get lower interest rates and have more options.”
If you feel confident about your credit score, then start gathering documents to show your income and debt-to-income ratio; the lender will want a ratio below 43%, says Reed. If your overall financial situation is healthy, then you’re more likely to get approved for the amount you’d like to borrow.
You’re Willing to Trade Fewer Fees For a Higher Interest Rate
A personal loan for home improvement tends to come with fewer fees than a home equity loan or a HELOC.
For example, it does not have application fees, appraisal fees, annual fees, points, or title search and title insurance fees, like home equity loans and HELOCs usually do. When comparing the price of a home equity loan and a personal loan, it’s important to factor in these extra fees.
The downside with a personal loan is that you’ll likely have to pay a higher interest rate. Your interest rate and how much money the lender lets you borrow will depend on your credit score, income, and debt-to-income ratio.
You’re OK With Losing Out on Tax Benefits
When you use a home equity loan, HELOC, or cash-out refinance for home improvements, you can usually deduct interest on the loan from your taxes. That’s because you’re using the funds to buy, build, or substantially improve your home, and because it’s a secured loan.
If you’re using an unsecured personal loan to fund your home renovation, you might not be able to deduct the interest you pay. Make sure to talk to an accountant or tax advisor to get more clarity on your specific situation.
Alternatives to Personal Loans For Home Improvement
Tapping into home equity is a popular way to fund a home renovation project, more so than taking out a home improvement loan. Here are some options to consider.
Home Equity Line of Credit (HELOC)
A HELOC works kind of like a secured credit card, with a revolving line of credit. You can draw up to 85% of your home’s value, and you can draw money as you need it. You can even borrow more as you pay off your balance, but you have to put your home up as collateral.
It can be a flexible and cost-effective way to fund an ongoing home improvement project. However, because HELOCs have adjustable rates, which could go up in the future, Moralez says you should only go this route if you will be able to pay off the debt quickly.
Home Equity Loan
A home equity loan is sometimes referred to as a second mortgage. Like a personal loan, the money you borrow is disbursed up front, and you repay over time in fixed monthly payments. With this type of loan, your home is used as collateral.
A cash-out refinance resets the clock on your mortgage and operates differently from a home equity loan or a HELOC.
In this type of refinance, you would take out a mortgage for more than you owe on your house and use the difference to fund your home improvement project. This is an option only if you have enough equity in your home.
You’ll have a completely new mortgage and interest rate, so you’ll have to pay closing costs on the new mortgage. (Those costs can be rolled into the loan, so you don’t have to come up with the money up front.)
But it’s a great option right now while interest rates are extremely low, says Reed. And that’s what makes a cash-out refinance especially attractive.