Home Improvement Loan vs Home Equity Loan

Home Improvement Loan vs Equity Loan

When selecting a home improvement loan, there are some advantages. First, you can borrow up to $100,000 with a home improvement loan without providing collateral. Since there's no collateral, the approval and funding process is usually much simpler and faster too. You can take advantage of fixed monthly payments and in most cases you can pay the loan off early to save on interest. Qualifying for a home improvement loan is usually easier than qualifying for a home equity loan.

To qualify for a home equity loan, you will need equity in your home. In most cases, you can borrow 80% to 85% of your home's value minus what you owe. All equity-based financing options run the risk of foreclosure since the equity in your home is used to secure the loan or line of credit in case you fail to pay. Many consumers don't like to use equity-based financing like home equity loans because they prefer to avoid this risk.

Home equity loans may carry a much lower interest rate than home improvement loans do. The average interest rate of a home equity loan in 2022 is just 6%, while the average interest rate of a personal loan in 2022 is approximately 11%.

Equity-based forms of financing will most likely require an updated appraisal to be completed on your home in order to determine its current property value. This along with other types of red tape can make the application and underwriting process take much longer than that of a personal loan. Most personal loans fund within a few business days, with loans from online lenders like LightStream taking just 1-2 business days before the funds hit your bank account.

Lastly, the loan repayment period of a home equity loan is much longer than that of a personal loan. Most home equity loans are repaid over decades, although loan terms can range from 5-30 years. On the other hand, personal loans are typically repaid over a shorter period of time ranging from 1-12 years. This can be an advantage or a disadvantage depending on what your financial goals are. If you want to get out of debt sooner, a personal loan with a short loan term is a better option for you. On the other hand, if you want to have the most affordable monthly payment, a home equity loan with a repayment period of 20 or 30 years will do the trick.

What is the difference between HELOC and Home Improvement Loan?

A home equity line of credit allows consumers to have ongoing access to a revolving line of credit, while a home improvement loan is a form of installment loan that is set up to repay a lump sum in equal monthly payments. There are several different types of home improvement loans, but they all will require repayment over a set loan period.

A HELOC uses the equity in your home to secure your financing and essentially insure the lender against the possibility of you defaulting on the repayment of your credit balance.

For this reason, some consumers avoid this type of financing because they don't want to take on the additional risk of foreclosure. However, because it is a secured form of financing, interest rates will be much lower, making HELOCs a very attractive option for many borrowers.

On the other hand, home improvement personal loans have higher interest rates but carry none of the risk associated with equity-based forms of financing like HELOCs. A personal loan can be applied for in minutes online and funded within just a few business days. You will receive a lump sum payment that can be used for anything you would like, including home improvement projects or any other major expense. Home improvement loans are a very popular way to finance your home repairs.

Consumers can also take advantage of government-backed rehab loans like the FHA 203(k) loan, a cash-out refinance mortgage, a home equity loan, credit cards, or in-house financing.

Each of these forms of financing has its own set of pros and cons for consumers to consider. You will need to do your research and decide which type of financing is right for you.

HELOC:

Revolving line of credit

Secured by equity in your home

Terms between 5-30 years

Only pay interest on money you draw

Home improvement loan:

Installment loan

Unsecured (in most cases)

Terms up to 12 years

Must pay interest on full loan amount

Is a Home Improvement Loan the Same as a Mortgage?

While not all home improvement loans are structured as a mortgage, there are some renovation loan programs that allow you to finance your home improvement projects as a part of your mortgage. The most well-known of these programs is the FHA 203(k) rehab loan, although other lesser known loan programs include Freddie Mac CHOICERenovation® Mortgages, and Fannie Mae HomeStyle Renovation loans. A traditional home improvement loan is not the same as a mortgage.

Can I Use the Equity in My Home to Renovate?

You can use the equity that you have built in your home to take out a variety of equity-based financing. With at least 15-20% equity in your home, you can utilize a home equity loan, home equity line of credit (HELOC), or a cash-out refinance. These methods allow you to take out up to 80%-85% of your home's equity in cash and repay it over time. When you initiate a home equity loan, HELOC, or a cash-out refinance, you can use the funds for whatever you would like.

Unlike FHA 203(k) loans and other types of home reno mortgages, your funds are not subject to any restrictions or approvals. However, if you do use the money to renovate, the interest you pay might be tax deductible, so be sure to keep good records of how you spent the money.

How to Calculate Your Home's Equity

To determine your home's equity, you will need to first know your home's current value. Then you will subtract the total amount of any liens on the property such as a mortgage or a home equity loan. For example, if your home is worth $100,000 and your mortgage has a balance of $80,000 then the equity you have in your home would be $20,000. Alternatively, if your home is worth $250,000 and your mortgage is for $150,000 but you have a home equity loan out for $25,000, then your current equity in your property would be just $75,000.

It is never a good idea to owe more on your home than it is worth. For this reason, most providers of home equity loans and lines of credit will not allow you to take out more than 80% of your total equity. This protects you from being upside down in your home loan.

Should I Use a Home Equity Loan?

There are many advantages to using a home equity loan, but this type of financing isn't for everyone. If you don't mind taking on the risk of foreclosure that comes along with using any type of equity-based financing, a home equity loan can be a great option for your home reno.

Home equity loans typically come with much lower interest rates than other forms of financing such as personal loans and credit cards. In fact, the current average interest rate for a home equity loan is just 6% (while personal loan interest rates sit around an average of 11%).

What is Not a Good Use of a Home Equity Loan?

If you are putting your family's home on the line by taking out a home equity loan, you will want to make sure that the risk is well worth it. In addition to making sure that you can afford the repayment of the loan, you'll want to make sure that you are putting the money to good use. Any home improvement project that increases the value of your home or helps you afford a necessary repair is a good use of a home equity loan. Another common reason that many people take out home equity loans is to pursue debt consolidation or higher education. These may be worthwhile reasons that make taking out a home equity loan a smart financial decision.

On the other hand, taking out a home equity loan for frivolous expenses such as putting in a game room or taking an expensive vacation may not be the best use of your funds. Anytime you will be going into debt, you want to make sure that funding the major expense is worth it. Don't forget to factor in the fees and interest you will pay over the lifetime of the loan when you are calculating the total cost. Once you look at the big picture, it may not be a wise idea to finance that dream vacation or luxury home upgrade if you don't have the funds to pay upfront.

What Are the Disadvantages of a Home Equity Line of Credit?

The main disadvantage of a home equity line of credit is that your home's equity is used as collateral to secure the financing, meaning that your home is subject to foreclosure if you fail to repay. Many people chose to avoid equity-based forms of financing for this reason alone.

Additionally, if you do not have a large amount of equity in your home (at least 15-20%) you may not even be able to qualify for a HELOC in the first place.

A home equity line of credit may come with a variable interest rate that is subject to fluctuation with current market conditions. This can make repayment costly and difficult to predict. In addition, you might be tempted to overspend with an open line of credit as opposed to taking out a loan which comes in a single lump sum. Many consumers are not able to handle the temptation of having available credit without spending it all, even after they should have repaid the balance off long ago.

Can You Pay Off a Home Equity Loan Early?

As with most other types of financing, you can typically pay off a home equity loan whenever you like. The only caveat is that you may be subject to an early repayment penalty depending on the lender. However, even if you do need to pay a fee, it will be worth it to get out of debt.

In addition, if you sell your home before your home equity loan is paid off, the balance will be due at the time of closing, so be sure to factor this into your plans.

What is a Good Alternative to a HELOC or a Home Equity Loan?

Although HELOCs and home equity loans are a fairly popular financing option, not everyone likes to use their home's equity to get funding or has enough equity in their home to do so.

As an alternative to equity-based forms of financing like a HELOC or home equity loan, consumers can take advantage of a home improvement personal loan or pursue financing through a renovation mortgage like an FHA 203(k) rehab loan.

Home improvement personal loans make a great option for financing because they are flexible, easy to apply for, easy to qualify for, come in amounts of up to $100,000 with little to no loan restrictions, and carry no risk of foreclosure if you default on the loan. Personal loan interest rates currently sit at an average of 11%, although the rate you receive will be based on your credit score and a few other determining factors.

Credit cards can be a great way to finance your home improvement projects as well if you can score a 0% introductory interest rate. Some credit cards have a promotional period lasting between 12 and 24 months which allows consumers to avoid paying interest on purchases made during the introductory period. If you have a small inexpensive home renovation project, using credit cards instead of a home equity loan or HELOC can save you money on interest.

What are the Requirements for a HELOC or a Home Equity Loan?

While requirements for a HELOC or home equity loan will vary from lender to lender, there are a few basic things to keep in mind if you are considering starting an application for one.

Generally, homeowners must have at least 15-20% equity built up in their home in order to take out a home equity loan or line of credit. For example, if your home is valued at $250,000, your lender will want to see that you have between $37,500 and $50,000 worth of equity in it.

In addition, lenders want to see that borrowers have a decent income, a low debt-to-income ratio, a good credit score, and a stable employment history. Your credit score should ideally be at least 660 or above in order to qualify for a HELOC or a home equity loan and to gain access to the best interest rates. Your debt-to-income ratio would ideally be 43 percent or lower.

Should I Use a Home Improvement Loan?

If you are undergoing some minor or major home repairs that need some financing, a home improvement loan is a far better choice than using credit cards in most cases. The only exception to this is if you can find a credit card with a 0% introductory period interest rate.

However, home improvement personal loans offer consumers one of the best ways to finance their home improvement projects with little to no fees, few restrictions, lenient application requirements, and short funding timelines. Most personal loans are able to deliver the loan proceeds to you in as little as 1-2 business days, especially if you apply online.

This is in contrast to home equity loans, home equity lines of credit, government-backed rehab loans, cash-out refinances, and other types of financing that can take months and mountains of paperwork in order to get started. There are no appraisals needed for a personal loan, no closing costs, no private mortgage insurance, and no inspections or approvals needed for the work being done.

For these reasons, many consumers choose to use a home improvement loan to finance their home renovations. Whether or not you should use a home improvement loan will depend on your own personal financial situation and what you are looking for in a form of financing.

Overall, home improvement personal loans offer homeowners a convenient way to fund their renovation purchases and labor costs when they can't afford to pay for them upfront.