Home Equity Loan vs Home Improvement Loan: Pros and Cons

Home Equity Loan vs Home Improvement Loan: Pros and Cons

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Home equity loans usually have lower interest rates than comparable home improvement loans, but the fact that the lender places a lien on your home with home equity financing might make a home improvement loan seem like the better deal.

Despite the tradeoffs, both types of financing are popular among home flippers and DIY homeowners. We cover which type of financing might be best for your home improvement project, and what the pros and cons are for each.

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What’s the difference between a home equity loan and a home improvement loan?

Home equity loans are loans collateralized by the value of your home which can be used for home repairs and renovations, in addition to any other purpose the borrower deems appropriate. Home improvement loans are personal loans specifically dedicated towards renovations on your home. Here's a point by point comparison of each.

Risk

Since home equity loans are seen as collateralized (with your house being the collateral) banks offer them at lower interest rates, while personal loans are non-collateralized and tend to have higher interest rates.

Unlike a home equity loan, home improvement loans don’t put your home at risk. Although they’re called a variety of things, a home improvement loan is basically a personal loan that’s used specifically for home improvement projects.

Borrowing limits

With home equity loans, lenders may allow you to borrow a portion of your home’s total value (generally, around 80% to 90% of it, at most) — as long as your loan-to-value ratio is below that number. Your loan-to-value ratio is a percentage that’s calculated by dividing the total amount you owe on your home by the total value of the property.

Personal loans for home improvement projects range from lender to lender, and how much you can borrow depends heavily on your debt-to-income ratio and other eligibility factors. The average home improvement loan borrowed is $12,384, according to a recent LendingTree study. (Note: LendingTree is the parent company of ValuePenguin.)

Repayment

Home equity loans are repaid over a longer period of time than most personal loans — typically five to 15 years. Personal loans usually have a fixed shorter repayment period, typically lasting one to five years. Both types of loans are typically disbursed as a single lump sum payment, although home equity lines of credit (HELOCs), a type of home equity loan, can be drawn upon and repaid at will over an extended period of time.

Rates

Home equity loans typically have low, fixed interest rates, making it easy to budget what you need to pay back each month. Home equity rates currently average about 5.76%. They may carry a lower rate other types of debts because the lender has collateral to fall back on — in this case, your home — in case you miss payments. The rates for a personal loan vary greatly depending on your credit score and lender. Case in point: average personal loan rates can be between 10.30% to 32.00% APR depending on your score. However those with excellent credit can qualify for competitive rates that price slightly above comparable home equity debt.

Are home equity loans good for home repairs?

Home equity loans can be a great choice for expensive home improvement projects that add value to your home. If you know how much you need up front and are prepared to repay the debt with regular monthly payments for several years, a home equity loan might be the right choice.

Home equity loans also come with a nice tax benefit, allowing borrowers who use the loans to buy, build or improve their homes to deduct paid interest from their taxes, though this benefit is capped at $750,000 in home loans. This benefit also applies to other types of second mortgages, including home equity lines of credit.

When considering a home equity loan, you’ll need to budget for the associated closing costs and fees, which can amount to 2 to 5% of the loan amount.

Is a home equity loan better than a home improvement loan?

A home equity loan may be a better choice if the cost of your home repairs is unusually high, you own a significant portion of your home in an appreciating real estate market, or if you want to get the best interest rate over a long period of time.

While home equity loans allow you to borrow large amounts at low interest rates, they also put your home at risk due to the lien that the lender holds over your property. Personal loans don’t put your home at risk, but their generally higher interest rates might make you think twice if you're planning on borrowing significant amounts. Personal loans also don’t offer any associated tax benefits, so don't expect to be able to write any of that interest off come tax season.

Although home improvement loans are granted more quickly than home equity loans, the repayment period is also shorter — which, combined with the higher interest rates, can make your monthly payments less affordable. While home equity lenders tend to offer terms of 5 to 15-year, personal loan companies often cap the terms on your home improvement loan at 5 – 7 years or less.

Personal loans also do not require you to have equity in your home, which can be especially handy if you recently purchased your property and haven't had a chance to build up your stake. A personal home improvement loan allows you to start on your home improvement projects right away.

If you choose to use a personal loan, just be sure the expected value of your home improvement project offsets the higher interest you’ll be paying for it. Keep in mind that you'll be responsible for the higher monthly payments on your loan in addition to your outstanding mortgage, so it's a good idea to budget for the long run before taking out either option.

Alternatives to home equity loans and home improvement loans

Both home equity loans and home improvement loans pay out a single lump sum upfront and charge you interest on the entire balance until the debt is paid off. While straightforward, this isn't the ideal solution depending on the needs of your job. Here are a few alternatives that give you more say on when you take out the money and what you'll be charged interest on.

HELOCs

HELOCs are revolving lines of credit that uses your home as collateral. Unlike a home equity loan, you only pay what you borrow, so you can use this credit to pay for home improvement projects as they come up, instead of having to take out the entire lump sum up front. Keep in mind that HELOCs typically have variable interest rates, meaning your payments may change over time.

If you’re not exactly sure how much you’ll need to borrow, the flexibility of the HELOC might better suit your needs than a home equity loan. Both types of loans allow you to benefit from their comparatively low interest rates (currently an average of 5.76% for 15-year home equity loans and 5.51% for HELOCs) and the interest on both HELOCs and home equity loans is tax deductible if used for qualified home renovation costs.

0% APR credit card:

Besides a HELOC, you might consider opening a credit card with a 0% introductory APR and a high enough credit limit to cover your home renovation expenses. This would essentially work as well as a personal loan — and with a 0% introductory APR, you may not end up paying a penny of interest in your first year.

Just keep in mind that these introductory APRs end quickly — only giving you a year to pay off your debt in full before standard interest rates kick in. While a year might sound like a long time, this could end up being an overly aggressive repayment plan depending on how much you intend to borrow. Some cards also charge deferred interest, which means you’d be retroactively charged interest on the entire remaining balance if you're unable to pay it off in full within the promotional period.

401(k) loan

Yes, you can actually borrow money against your retirement plan for a home improvement project. But just like a home equity loan, a 401(k) loan comes with the inherent risk of losing part of your nest egg if you default on the loan.

The positive aspects of these loans include their low interest rates and the fact that instead of paying interest back to a lender, you’re paying it back to your retirement account. The timeline of five years is also comparable to the typical terms on most personal loans.

It's worth noting that any outstanding loans against your 401(k) account may be declared taxable if you were to lose your job before you’d paid off your loan. In most cases, you would have to repay the entirety of your remaining loan balance within a short period of time, generally about 60 days, before the IRS declares the outstanding debt a distribution and taxes you on the outstanding balance. While 401(k) loans are an option for home improvement projects, they also come with more risk and should not be taken lightly.

What is the best way to borrow money for home renovations?

Like many lending scenarios, there isn’t one single solution that’s best for everyone. To determine which form of borrowing makes the most sense for you, take the time to consider your finances and your preferred method of repayment.

If you feel confident about your repayment plan and want something you can pay off over time with low interest rates, a home equity loan might make sense. But if the risk involved in a home equity loan or 401k loan sounds intimidating, you may want to stick with a personal loan or low interest credit card — something that doesn’t place your home or retirement plan in jeopardy.

Whatever you choose, don’t take on any debt without a realistic plan in place to repay it. It's a good idea to put in the extra time and shop around for the best deals before committing to a single lender.

*The information in this article is accurate as of the date of publishing.

Kenny Zhu

Kenny is a Banking and Mortgage Research Analyst for ValuePenguin and has worked in the financial industry since 2013. Previously, Kenny was a Senior Investment Analyst at PFM Asset Management LLC. He holds a Bachelors of Science from Carnegie Mellon University, where he majored in International Relations & Politics. He is a CFA® charterholder.

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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