Popular Loan Options for Home Improvement Projects

Home improvement has surged in popularity since the start of the coronavirus pandemic, and many homeowners are looking at ways they can better function in their space. While you may want to knock out that wall between the kitchen and dining room, or maybe add another bathroom, funding those huge home projects becomes, well, a project in itself.

Major renovations or additions can cost tens of thousands or more, making a loan option likely for many homeowners. Rather than racking up debt on a high-interest credit card, consider the range of loan options available. Each comes with a specific set of pros and cons.

“The COVID-19 pandemic has really shown many current homeowners that their space is not quite adequate for their needs,” says Jason Gelios, a Michigan-based author and Realtor with Community Choice Realty. “With the housing market favoring sellers, many homeowners are choosing to renovate versus moving to a new space. With rates still at historic lows, the home equity line is a great option to finance a home project.”

All lenders and banks have different rules and regulations. Be sure to check with a financial advisor before making a significant investment in a project.

What Improvement Project Are You Funding?

The first question you should answer before applying for a home improvement loan is what you plan to use the money for. Are you planning to upgrade your primary residence or fix up an investment property? Depending on the project, there are differences in how much you can borrow and what loan types you’re eligible for.

For instance, a 203k loan combines expenses for purchasing a home and the improvements that home will need, which is great for a new investment. However, 203k loans require the owner live in the property for a year, which is not optimal for a quick-turnaround investment flip.

If you want to improve your current, primary residence with a major renovation, a home equity line of credit (HELOC), home equity loan, cash-out refinance and personal loan are all popular options.

Comparing Different Loan Types

Picking the right loan will also depend on a few factors — how long you’ve owned your home, what your interest rate was when purchasing your home, and if you’ve gained substantial equity through previous home improvements and/or neighborhood value increases.

Equity is essentially the appraised value of the property minus the amount you owe on your mortgage. For example, if your property is valued at $300,000 and you have $200,000 remaining to pay, you have $100,000 in equity.

Equity can be a great way to fund a home improvement project. Lenders will often issue a line of credit based on the amount of equity you have. Using the example above, a HELOC loan would allow you to borrow between 70 percent and 90 percent of your equity, or $70,000 to $90,000, to fund a home project. (The percentage varies by lender). Some equity-based loans may allow you to withdraw up to 100 percent.

So which loan option is right for you?

Home Equity Line of Credit (HELOC)

A HELOC, unlike other loan options, gives you an open line of credit to borrow and spend as you need rather than a lump sum. That also means rates fluctuate. One benefit of a HELOC: Low or no closing costs.

“Prior to the pandemic, the HELOC was still the number one choice for homeowners looking to pull cash out for home renovations,” Gelios says. “Homeowners were attracted to the low interest rate, the ability to only use what money they need on their terms, plus being able to pay off portions of the loan and have that available again at a later date.”

HELOC loans, due to their similarities to a credit card, do not stipulate how or where you spend the money, including paying off other debts or projects. One thing to consider when using a HELOC is the amount you need to fund your improvement project and how the interest rates compare to another loan option like a cash-out refinance.

“As of now, even with rates rising, the interest paid on a HELOC is higher than that of a cash-out refinance,” says Zachary Hafer, a professional mortgage lender with American Financial Network.

“There are pros and cons to both, the first being that a HELOC will give you access to 90 percent of your home’s equity versus a cash-out refinance that gives you up to 80 percent. That being said, the interest on the HELOC loan is going to be higher than that of a cash out refinance, especially since the pandemic and interest rates dropping to record lows.”

Home Equity Loan

Unlike a HELOC, a home equity loan does not allow you to go back and get more money as you need it. So if you go over budget for your renovation, you can’t borrow more. A home equity loan (HEL) is a great option for homeowners with established equity in their property who are only planning one major renovation.

Also, a HEL has a fixed interest rate, which might be good to capitalize on now while rates are low. HELs offer low interest rates for homeowners with good credit and substantial equity. However, plan to pay closing costs.

FHA 203(k) Rehab Loan

A 203k loan is backed by the Federal Housing Authority (FHA), and therefore has a larger list of qualification requirements and regulations than other loan options.

The pros with a 203k loan? Homeowners do not have to apply for separate loans — one for repair and one for purchasing a home — as it bundles them into one. Also, being an FHA loan, it only requires a 3.5 percent down payment, a great option for first-time home buyers.

However, being a government-backed loan, there are some cons . A 203k loan is designed for older and dilapidated homes that need major improvements costing at least $5,000. There are strict requirements on who can do the repair work. FHA loans also require mortgage insurance, which can be hundreds of dollars every month that doesn’t go toward increasing equity in the home. Private mortgage insurance (PMI) protects from foreclosures.

“You need to use 203k approved contractors for all of the work, and they base the value of your home off what the contractors have provided as far as fits and finishes,” Hafer says. “Those loans do take longer to fully complete, however, because you are at the mercy of the time it takes for all of the work to be finished.”

The two types of 203k loan are streamline and standard. Streamline is for livable homes with a capped rehab limit. Standard, which has more application requirements, has no cap limit.

“The main thing to keep in mind for a rehab loan is, a lender isn’t going to allow you to borrow more than the house worth at the end of the project, known as the After Repair Value (ARV),” says Justin Siddall, the owner of the Florida-based investment company Better Together Properties. “That means the current value plus remodel budget plus project buffer needs to be less than the ARV.”

Siddall suggests asking about Fannie Mae’s Homestyle Renovation Loan program and Freddie Mac’s CHOICERenovation Loan.

Cash-out Refinance

A cash-out refinance lets you take out a substantial amount of money if you have substantial equity in your property. Among the benefits of a cash-out refinance: You no longer need to pay PMI, and you reduce your loan interest rate to the lower current standards.

“When a majority of people buy their first home, they have a mortgage insurance premium on their loan for the life of it if they used an FHA loan,” Hafer says. “So in addition, using a cash-out refinance can also switch you from an FHA loan with a mortgage insurance premium to a conventional loan that can cut that off completely as well.”

When deciding if a cash-out refinance is right for you, you’ll need to determine if a lower interest rate is worth a larger mortgage balance, a longer term to pay it off, and paying hundreds or thousands in closing costs.

Personal loan

The biggest benefit of a personal loan is that you don’t need massive amounts of equity to qualify, unlike HELOCs, home equity loans and cash-out refinancing. But if you lack significant equity as collateral, you might be subject to higher interest rates and/or lower borrowing limits. Rates and loan amounts will largely depend on the homeowners’ credit history.

Other benefits to personal loans are the quick application process (same-day fast, in some cases) and a consistent repayment plan.