While millions of Americans watch home-improvement and house-renovation shows on television every day, few people have the cash on-hand to self-finance any significant remodeling projects, even if they would be worthwhile investments and increase the home’s market value. That’s why home improvement loans have proven to be an increasingly popular option among homeowners. To help you decide if a home improvement loan is right for you, and how to go about getting one, we’ve put together this guide to everything you need to know about home improvement loans.
What Is a Home Improvement Loan?
As the name suggests, a home improvement loan is a loan taken out to finance home improvement projects like an extension or a significant remodel. Most times, the home provides the collateral for the loan. When a home improvement loan is secured by property as collateral, it is called a secured loan. An unsecured loan does not involve the use of collateral, which means that the lender could not foreclose on your home if you do not repay. However, as one might expect, an unsecured loan typically requires an exceptional credit history, and a demonstrated ability to make the required payments.
How Do Home Improvement Loans Compare to Other Options Like Credit Cards or Home Equity Lines of Credit?
For those looking to borrow money to finance their home renovations or remodels, home improvement loans are not the only options. Some homeowners opt to pay using their credit cards while others may opt for a home equity line of credit. However, as anyone who has ever suffered from credit-card debt knows, the exorbitant interest rates make credit cards a poor funding source unless you have to have those airline miles and you can pay off the debt before interest accrues. Home equity lines of credit or loans are another option though these typically come with higher fees and interest rates.
Can I Get a Secured Home Improvement Loan If I Already Have a Mortgage?
If you don’t qualify for an unsecured home improvement loan but you have an existing mortgage, it still may be possible for you to get a secured home improvement loan. When determining whether to give you a loan using your home as collateral, one of the most important factors a lender will consider is the amount of equity in your home. If you have sufficient equity in your home, you often will be able to find a lender to give you a loan. However, lenders almost always charge higher interest rates for second or third mortgages, as they are considered more risky investments for the lender.
What Is Equity and Why Does It Matter to Lenders?
The amount of equity in your home is equal to the market value of your home minus any debts or liens attached to it, such as a mortgage. For example, to use round numbers, if a home is worth $1 million, and there is a mortgage on it with a remaining balance of $300,000 but no other debt, then the home’s equity is $1 million minus $300,000, or $700,000.
This is how properties can accrue multiple liens or mortgages against them. In our example, a lender may give a second mortgage of $200,000, because even after that loan, there would still be $500,000 ($1 million market value minus $300,000 first mortgage minus $200,000 second mortgage) of equity in the house as a cushion against declining home values. The less equity you have in your home, the less likely it is that you will be approved for a secured home improvement loan.
What Is Loan-to-Value Ratio?
When determining whether to give you a home improvement loan that uses your home as collateral, another important equity-related metric lenders look at is the loan-to-value ration, which is the ratio of the dollar amount of the loan to the dollar amount of property value. Because property values are always fluctuating, lenders like to give themselves some cushion in case of a market decline.
Most lenders dislike being in a position where the total loan-to-value ratio (that is, the dollar amount of ALL loans on the property against the property’s fair market value) is greater than about 75%, and, the higher the loan-to-value ratio, the higher the interest rate a lender will charge even if you get approved for the home improvement loan.
What You Should Know When Applying for Home Improvement Loans
One reason lenders will offer relatively low interest rates on home improvement loans is because they are for a narrow, defined purpose that almost always will increase the home’s value, and with unsecured home loans, they are typically only are offered to well-qualified borrowers. So, you may ask yourself, how do I make myself one of these highly qualified borrowers?
What Can I Do to Improve My Chances of Getting a Home Improvement Loan?
If you are trying to get an unsecured home improvement loan, the lender will need to have solid evidence you are highly likely to repay the loan. Other than taking the usual steps to keep your credit score as high as possible, there are other simple measures you can take to improve your chances.
The first thing you can do is to keep your loan amount as low as possible. Although some lenders offer home improvement loans as high as $100,000, the more money you are asking for, the more closely the lender will scrutinize you, so anything you can do to keep your asking amount low will improve your chances of the lender saying yes. Also, the less money you borrow now, the less principal and interest you will have to pay back later, saving you money on interest and fees down the road and making your monthly payments lower.
Another consideration that often helps give a lender confidence when making home improvement loans is to present the lender with specific information about your home renovation or remodeling project, including how much it will cost and the timeline for completion. This will give the lender added confidence that you will use its money in the way you say it will and that it won’t be squandered.
What Different Terms Are Available for Home Improvement Loans?
When deciding among home improvement loans, there are many options to choose from. Aside from the obvious terms to look out for, like loan amount and interest rate, a potential borrower also needs to consider fees, penalties, repayment period, and whether the rate is fixed or variable. All of these considerations can end up meaning thousands of dollars down the road, so it’s important to do your homework up front to help avoid potential pitfalls down the road.
Loan Amount on Home Improvement Loans
While it can be tempting to take out as much money as possible, it is important to remember that this money isn’t free. In fact, it can be downright expensive. Some lenders command interest rates upward of 35% from less-qualified borrowers, so you can save yourself a lot of money by taking out as small a loan as possible.
Interest Rates on Home Improvement Loans
When comparing interest rates on home improvement loans, it is important to realize that you pay that rate, known as the Annual Percentage Rate (APR) every single year on your loan’s outstanding balance. That means that even if you get a loan with an interest rate of 20% APR, on a five-year repayment plan, you could still end up paying total interest amounting to more than half the original loan balance.
There is a wide range of interest rate calculators available online, and every potential borrower should spend time with one crunching the numbers and determining if it might be helpful to wait a year or two on the remodeling while you set aside more money, rather than taking out a home improvement loan. While highly qualified borrowers might get home improvement loans for as little as 5-6% APR, borrowers with fair credit will probably pay around 20%, and less-qualified borrowers may pay as high as 35-40%.
Length of Home Improvement Loans
It makes good financial sense to pay off any loan as quickly as possible. That’s because while long-loan terms can be tempting, with their low monthly payments, the longer the length of the loan, the more interest one will end up paying. Therefore, the shorter the loan term, the better, as long as you can afford the monthly payments.
Other Important Terms for Home Improvement Loans
Other important terms to look out for when comparing home improvement loans include the various penalties and fees that a lender may charge under certain conditions. For example, if you think you will pay off your loan faster than the loan documents call for, you will want to check to see if there are any penalties for early payoffs.
Similarly, you’ll want to see whether your monthly payment will change over the life of the loan or if it will stay the same. Also, check to see if there are any other hidden fees or penalties. Once you’re locked into a loan, it is exceedingly difficult to get out of it without taking an enormous hit to your personal credit and, if it is a secured loan, potentially losing your home, so it’s very important that you fully understand the terms of your home improvement loan before signing the final papers.
Whether you need fast cash for emergency repairs or you don’t want to put off that remodel any longer, home improvement loans can be a good source of funding for your home renovations projects. However, as with any sort of credit, it is important to do your homework in advance to understand what you are getting yourself into and to make sure it is a financial decision that makes sense for you and your family. Otherwise, it might be worth putting off those renovations for a little while.