How to Pay for Home Renovations: Using the Right Tool for the Right Job

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The right type of loan for your home renovation project depends on the scope of the work, how much equity you have, and how much you can afford to repay each month. In this article, we’ll look at the different types of financing and the circumstances in which they apply.

We've divided these financing options into "fixed rate loan" solutions which include a lump payment and a known cost, and "flexible" solutions, which give you more leeway to draw on additional funding as needed and doesn't require you to borrow a huge amount upfront.

Fixed Rate Loan Options

Lump sum options are better when the borrower needs all of the money at once, knows exactly how much the project will cost, and wants to be able to pay it off in consistent amounts over time.

These generally permit the largest loan amounts but all of the money is paid to the borrower upfront at closing. If you need more money after the funds are disbursed, you'll need to find other solutions. It's therefore a good idea to have more certainty regarding your project costs while keeping your overall costs in mind.

Home Equity Loans

A home equity loan offers a lump sum cash disbursement, typically paid back in fixed monthly installments, similar to a traditional mortgage. Using your home as collateral, lenders generally offer lower interest rates and longer payback periods on home equity loans than on comparable unsecured personal loans.

Just like a mortgage, you may need to pay closing costs and fees to get a home equity loan, as well as have the home appraised. A home equity loan is one of the more cost-effective options for major renovations. But your house acts as collateral for the loan, so you could lose your home to foreclosure if you’re unable to make the payments — so factor that in to how much you borrow. You might be better off doing smaller renovations at a lower cost than taking on large payments you can't afford.

Cash-Out Refinance

A cash-out refinance is similar to a standard mortgage refinancing, but also cashes out a lump sum of your home equity at closing. The amount you're able to cash out will depend on how much equity you own in your home. This accomplishes two goals:

  1. Refinancing your current mortgage rate, and
  2. Withdrawing funds from your home value for other uses.

Here’s how it works: You apply for a new loan that includes the remaining mortgage balance plus the amount you want to take against your equity. You’ll receive the latter as a lump sum, which you can apply toward your renovations.

One of the benefits of a cash-out refinance is that it allows you to finance your new debt at the same rate as your new mortgage, though this varies based on your financial circumstances and the current rate environment. The interest rates on cash-out refinances are typically lower than comparable personal loans and home equity loans in many cases. Depending on the terms, you may extend your repayment period as well, lowering the amount of your monthly payments.

To qualify for a cash-out refinance, you'll usually need at least 20% equity in the home and a credit score of 620 or higher. In certain instances, the VA cash-out refinance can allow you to cash out as much as 100% of the equity in your home.

Title I Home Improvement Loans

A Title I Home Improvement Loan can be used for a range of expenses that improve accessibility on a home, such as adding an entrance ramp for individuals with disabilities as well as replacing major appliances. But it may not be used for luxury upgrades, and an FHA appraiser must approve any proposed renovations.

Backed by the FHA, Title I Home Improvement Loans do not require you to have any home equity built up nor does it require you to fall under a particular income threshold or have a minimum credit score. You will, however, need to provide proof of income, and your debt-to-income ratio must be 45% or less. Debt-to-income measures your total loan payments relative to your gross monthly income.

Under this loan program, you may borrow up to $7,500, unsecured. If you need more, you’ll need to use your home as collateral.

Personal Loans for Home Improvement

A fixed-rate personal loan for home improvement can be useful for small- to moderate-scale projects. Personal loans may be used for any purpose, including cosmetic upgrades or luxury renovations and don't feature the same constraints that Title I loans have. They can also be issued in greater amounts than Title I loans allow without collateral, but still fall home equity loans when it comes to overall loan amounts.

Unlike a home equity loan, a personal loan does not require that you use your home as collateral. Unfortunately, this means you’ll receive a higher interest rate but you won't have to risk foreclosure in the event of non-payment.

If the loan is for a relatively low amount, you might decide it makes more sense than taking out a home equity loan. You’ll need to look at the potential fees associated with the home equity loan versus the interest you’ll pay on a personal loan. Home equity loans sometimes require a borrower to pay closing costs while personal loans don't or require only a modest origination fee.

Flexible Lines of Credit

These products are great for short term and long-term projects where you're uncertain of how much money you need or when you need it. Rather than receiving your entire loan amount upfront, you receive access to a credit line that you can draw upon and repay as needed.

For lines of credit you'll only be charged interest on the amount you borrow. In some cases, this can actually save you money if you're able to pay it off entirely in the short run.

Home Equity Line of Credit (HELOC)

HELOCs are similar to home equity loans in that they are secured by your property. Where the two products differ is how the funds are disbursed. Recall that a home equity loan is a lump sum option, so you receive all the money at once. In contrast, a HELOC approves you for a line of credit up to a specific amount. You draw on the money as needed and only pay interest on the amount you’ve used.

Another drawback is that HELOCs are variable rate products, so if interest rates rise, you could end up with higher monthly payments than you originally anticipated. While some lenders offer fixed rate-locks on these credit lines, it's often the case that many HELOCs begin with an initial low teaser rate which adjusts to higher levels after a set period.

Using a line of credit may help you avoid borrowing in a scattershot way, said Luis Rosa, certified financial planner in Henderson, NV. “People might think a renovation is $10,000 for the kitchen, and then it’s $15,000,” he said. “They end up with one loan here, and then maybe borrow from a 401(k) and then put the difference on a credit card, and that’s not as advantageous.”

Credit Cards

Credit cards are not ideal for high-ticket projects, but you can use them strategically for smaller expenses that you can afford to pay off in full from month-to-month. Look for cards with 0% interest periods for purchases or balance transfers to cover more expensive purchases. Then pay them off in full before the introductory rate ends. Doing so enables you to finance renovation expenses interest-free while keeping cash on hand for emergencies.

Home improvement chains like Lowe’s and Home Depot offer their own credit cards with special financing and promotions. Features may include 0% periods, fixed rate financing on certain projects, and in-store discounts. Be sure to read the terms, though.

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