Home Improvement Loans: What Is It, How Does It Work And How To Apply For

Home improvement projects are often huge expenses that are difficult to manage with savings alone. In fact, the average American homeowner spends about $18,000 annually on home renovations.

Fortunately, you can make these costs more affordable by financing them with a home improvement loan. The interest rates on these loans are usually lower than credit card rates, and they come with fixed repayment terms and interest rates, which makes the monthly payments more predictable. However, there are some factors to consider before applying for one.

What is a home improvement loan?

A home improvement loan is a form of personal loan that is intended to cover both emergency home repairs and home remodeling or renovation initiatives. This can include anything from fixing a leaky ceiling to a complete kitchen remodel.

Types of home improvement loans

There are mainly five options for borrowing for housing projects:

Personal Loans: These loans are usually unsecured, which means they use your credit score and income to determine your eligibility. For this reason, they carry higher interest rates than the other types of loans listed below. However, if you have a stable source of income and excellent credit, you can get an interest rate as low as 4.6 percent. Personal loans are a great option for people who already have a fixed budget for their home improvement projects, as they are taken out for a fixed amount.

Home Equity Line of Credit (HELOC): A HELOC uses your home equity line of credit as collateral for the loan — which means you could lose your home if you default. Aside from these risks, they offer the same spending flexibility as credit cards, with much lower interest rates. HELOCs are better suited for people who have an ongoing home project and don't have a fixed budget.

Home Equity Loans: Like HELOCs, these loans use your home equity as collateral. Like a personal loan, you borrow a lump sum and pay it back in instalments. But their prices are lower because they insure your home. A home equity loan is an ideal solution if you have less than ideal credit and do not qualify for a lower rate with an unsecured loan.

Cash Refinancing: Cash refinancing involves exchanging your mortgage for a new loan that allows you to take advantage of your equity. For these types of loans, you will need a minimum of 20% of the equity in your home. It is best suited for a wide range of home renovations.

Government Loans: The U.S. Department of Housing and Urban Development (HUD) offers a type of loan, called a Title I home improvement loan, that can help you renovate your home at a very low cost, if you meet the eligibility requirements. These loans can also be used in conjunction with a 203(k) rehab mortgage, which is another government loan that allows eligible homeowners to roll over $35,000 into their mortgage for renovation or home improvement projects.

How does a home improvement loan work?

Whether you choose an unsecured or a secured home improvement loan, they basically do the same thing. You get a lump sum, which is paid over a specified period of time and at a fixed interest rate. This money can be used to pay for permits, contractors, equipment, materials, and labor needed to complete the work. This can be done for one large project or in parts if you are dealing with several smaller projects.

No matter how long it takes to complete the home improvement, you'll start making the monthly payments right away. Your exact payment amount will depend on how much you borrowed and your rate. When choosing a loan, make sure you have room in your budget for comfortable monthly payments - and to cover any unexpected expenses that may arise during the renewal process.

Where can I get a home improvement loan?

Most home improvement loans will either be unsecured personal loans or a secured loan that uses your home equity. This means that you will find options offered by online lenders as well as banks and credit unions.

Online lenders. There is a wide range of online lenders, many of which work with major banks to offer low rates. Unsecured personal loans are common, so you should be able to find a lender that matches your credit score and income.

Banks. These usually offer both personal loans as well as HELOCs or home equity loans. Start with the bank you already use, then compare rates from other national and local banks. In most cases, you will not need an account to apply. However, banks have stricter credit requirements than online lenders and credit unions, so you'll need excellent credit to qualify for these loans.

Credit unions. Unlike banks, you must have a credit union checking or savings account to qualify for a home repair loan. But unlike banks and online lenders, credit unions usually have lower rates and more flexible credit requirements.

Home improvement loan requirements

As with any loan, lenders consider your credit score, income, and debt when determining whether or not you qualify. A secured loan - like a HELOC - will also take the value of your property and the amount of principal in your account. The more equity you have and the higher the value of your home, the more likely you are to get a competitive price.

What credit score is required for a home improvement loan?

If you want to take out a personal loan to finance your home improvement project, you will likely need a credit score of at least 600 to qualify, or a credit score that meets this requirement. For secured loans, you will usually need a credit score of at least 620 to be approved.

However, to get the lowest rates, you will need good credit. In most cases, this means a score of 670 or higher. In addition, most lenders will require a lower debt-to-income (DTI) ratio, which is a measure of how much money you have left after paying all of your monthly bills. The ideal DTI for home improvement loans is 36 percent or less. Some lenders also have a minimum family income requirement, so be sure to check that before applying for a loan.

How to Get a Home Improvement Loan

Applying for a home improvement loan is similar to applying for a personal loan. Follow the steps below to make sure you get the best deal for your situation.

Research loan options and lenders. Since there are both secured and unsecured home loans, you need to know which one best suits your needs. Secured loans have lower interest rates on average, but they come with the risk of losing your property in the event of default.

Document collection. Lenders will need to see proof of employment, residence, and identification. Social Security numbers, bank statements, payment slips and information about your business and assets are all necessary to complete the application.

Apply for pre-qualification (if any). Pre-qualification allows you to evaluate potential rates without affecting your credit score. If you like what you see, you can submit a complete application by checking rates for lenders that do not offer pre-qualification.

Compare offers. Once you have submitted your application with a few lenders, compare offers. Consider the interest rate, loan term, and total cost of the loan, as well as other factors.

When You Can't Apply for a Home Improvement Loan

A home improvement loan is suitable if you have a large project with multiple costs. Weekends costing less than $1,000 are best covered by savings or a low-interest credit card.

Many personal loans will have a minimum amount that you can borrow. Some lenders allow up to $1,000. However, most will set a minimum amount of $2,000 to $5,000. This is especially true of loans that use your home equity. You should avoid borrowing more than you need, even if your loan does not have a prepayment penalty.

If your budget is really tight, you should also avoid debt. Even low-interest loans can be expensive, and you need to make sure you can make the payments to maintain your credit score. If you already have poor credit, look for ways to improve your score before applying for a loan.

Bottom Line

Home improvement loans are a major method of financing major projects. Although it is not suitable for every homeowner, it can be a powerful tool if you know your budget and have good credit.

Start by comparing lenders and seeing what your current bank has to offer. You may be able to find a good deal—just be prepared to do your research and provide details on how you can use your loan to upgrade your living space.