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June 17, 2018

6 Types of home improvement loans: Which is best for you?

Erik J. MartinThe Mortgage Reports Contributor

January 21, 2022 - 15 min read

Compare the best home improvement loans for 2022

Home renovations cost a lot. But the good news is, you don’t have to produce the cash out of pocket.

Home improvement loans let you finance the cost of upgrades.

For example, specialized home improvement loans like the FHA 203(k) mortgage exist specifically to finance home improvement projects.

And there are standard loans — like a cash-out refinance or home equity loan — that give you cash which can be used for home remodeling or anything else.

So, which home improvement loan is right for you?

Check home improvement loan options and rates. Start here (Jun 10th, 2022)

1. Cash-out refinance

One popular way to get money for a home remodeling project is with a cash-out refinance.

It works like this: You refinance to a new mortgage loan with a bigger balance than what you currently owe. Then you pay off your existing mortgage and keep the remaining cash.

The money you receive from a cash-out refinance comes from your home equity. It can be used to fund home improvements; although there are no rules that say cash-out funds must be used for this loan purpose. You can just as easily invest your cash, or put the lump sum into your bank account.

When a cash-out refinance is a good idea

A cash-out refinance is often best for homeowners who can reset their loans at a lower interest rate than their current mortgage.

You may also be able to adjust the term length to pay off your home sooner.

For example, let’s say you had 20 years left on your 30-year loan. Your cash-out refi could be a 15-year loan, which means you’d be scheduled to pay off your home five years earlier.

So, how do you know if you should use a cash-out refinance? You should compare costs over the life of the loan, including closing costs.

That means looking at the total cost of the new loan versus the cost of keeping your current loan for its life.

Keep in mind that cash-out refinances have higher closing costs, and they apply to the entire loan amount, not just the cash-out.

So you’ll likely need to find an interest rate that’s significantly lower than your current one to make this strategy worth it.

Cash-out refinance for home improvement: Pros and cons

Cash-out refinance pros:

Cash-out comes from home equity
You’d continue paying one mortgage payment
You can lower your interest rate or loan term at the same time
You can spend the cash on anything

Cash-out refinance cons:

Closing costs apply to a large loan amount
New loan will have a larger balance than your current mortgage
Refinancing starts your loan term length over

Check your eligibility for a cash-out refinance. Start here (Jun 10th, 2022)

2. FHA 203(k) rehab loan

An FHA 203(k) rehab loan also bundles your mortgage and home improvement costs into one loan.

But with an FHA 203(k), you don’t have to apply for two separate loans or pay closing costs twice. Instead, you finance your home purchase and home improvements at the same time, when you buy the house.

FHA 203(k) rehab loans are great when you’re buying a fixer-upper and know you’ll need loan funding for home improvement projects soon.

And these loans are backed by the government, which means you’ll get special benefits — like a low down payment, and the ability to apply with a less-than-perfect credit profile.

FHA 203(k) home improvement loans: Pros and Cons

FHA 203(k) rehab loan pros:

FHA mortgage rates are currently low
Your down payment can be as low as 3.5%
Most lenders only require a 620 credit score (some may go slightly lower)
You don’t need to be a first-time home buyer

FHA 203(k) rehab loan cons:

Designed only for older and fixer-upper homes
FHA loans include upfront and monthly mortgage insurance
Renovation costs must be at least $5,000
203k rules limit use of cash to specific home improvement projects

Check your eligibility for an FHA 203(k) loan. Start here (Jun 10th, 2022)

3. Home equity loan

A home equity loan (HEL) allows you to borrow against the equity you’ve built up in your home. Your equity is calculated by assessing your home’s value and subtracting the outstanding balance due on your existing mortgage loan.

Unlike a cash-out refinance, a home equity loan does not pay off your existing mortgage.

If you already have a mortgage, you’d continue making its monthly payments, while also making payments on your new home equity loan.

When a home equity loan is a good idea

A home equity loan may be the best way to finance your home remodeling projects if:

You have plenty of home equity built up
You need funds for a big, one-time project

A home equity loan “is dispersed as a single payment upfront. It’s similar to a second mortgage,” says Bruce Ailion, Realtor and real estate attorney.

With a home equity loan, your home is used as collateral. That means similar to a mortgage, lenders can offer lower rates because the loan is secured against the property.

The low, fixed interest rate makes a home equity loan a good option if you need to borrow a large sum. And you’ll likely pay closing costs on this loan. So the amount you’re borrowing needs to make the added cost worth it.

As an added bonus, “a home equity loan or HELOC may also be tax-deductible,” says Doug Leever with Tropical Financial Credit Union, member FDIC. “Check with your CPA or tax advisor to be sure.”

Home equity loan for home improvements: Pros and cons

Home equity loan pros:

Home equity loan interest rates are usually fixed
Loan terms can last from five to 30 years
You can borrow up to 100% of your equity
Great for big projects like home remodels

Home equity loan cons:

Adds a second monthly mortgage payment for homeowners that still owe money on their original loans
Most banks, lenders, or credit unions charge origination fees and other closing costs
Disperses one lump sum so you’ll need to budget home improvement projects carefully

4. HELOC (home equity line of credit)

You could also finance home improvements using a home equity line of credit or “HELOC.” A HELOC is similar to a HEL, but it works more like a credit card.

You can borrow from it up to a preapproved limit, pay it back, and borrow from it again.

Another difference between home equity loans and HELOCs is that HELOC interest rates are adjustable — they can rise and fall over the loan term.

But, interest is only due on your outstanding HELOC balance — the amount you’ve actually borrowed — and not on the entire line of credit.

At any time, you could borrow only a portion of your maximum loan amount, which means your payments and interest charges would be lower.

When a HELOC is a good idea

Because of these differences, a HELOC might be a better option than a home equity loan if you have a few less expensive or longer-term remodeling projects to finance on an ongoing basis.

Other things to note about home equity lines of credit include:

Your credit score, income, and home’s value will determine your maximum loan amount
HELOCs come with a set loan term, usually between 5 and 20 years
Your interest rate and loan terms can vary over that time period
Closing costs are minimal to none

And, by the end of the term, “The loan must be paid in full. Or the HELOC can convert to an amortizing loan,” says Ailion.

“Note that the lender can be permitted to change the terms over the loan’s life. This can reduce the amount you’re able to borrow if, for instance, your credit goes down.”

Still, “HELOCs offer flexibility. You don’t have to pull money out until you need it. And the credit line is available for up to 10 years,” Leever says.

HELOC for home improvement: Pros and cons

HELOC pros:

Minimal or no closing costs
Payment varies by amount borrowed
Revolving balance means you can re-use the funds after repaying

HELOC cons:

Loan rates are often adjustable, meaning your rate and payment can go up
Bank or credit union can change repayment terms
Rates are typically higher than for home equity loans

5. Personal loan

If you don’t have tons of equity to borrow from, an unsecured personal loan is another way to finance home improvements.

Because a personal loan is unsecured, you won’t use your home as collateral. That means these loans can be obtained much faster than HELOCs or home equity lines of credit. In some cases, you may be able to get loan funding on the next business day or even same-day funding.

Personal loans can have adjustable or fixed rates, but a personal loan normally has a higher interest rate than a home equity loan or HELOC.

That said, if you have excellent credit or even just good credit, you can likely get an affordable rate.

The payback period for a personal loan is less flexible: Often it’s two to five years. And you’ll probably pay closing costs.

Those terms might not sound all that favorable. But personal loans are a lot more accessible than HELOCs or home equity loans for some borrowers. If you don’t have much equity in your home to borrow against, a personal loan can be an option to pay for home renovations.

These loans also make sense to finance emergency home repairs — if your water heater or HVAC system must be replaced immediately, for example.

Personal loans for home improvement: Pros and cons

Personal loan pros:

Fast online application process
Funds available quickly; possibly on the same business day
No lien on your home required
Good for emergency home repairs

Personal loan cons:

Loan rates driven by creditworthiness
Lower borrowing limits
Shorter loan repayment terms
Some have prepayment penalties
Loans often have expensive late fees

6. Credit cards

You could always finance some or all of your remodeling costs with plastic, too. This is the quickest and simplest financing option for your home improvement project. After all, you won’t even need to fill out a loan application.

But because home improvements often cost tens of thousands of dollars, you need to be approved for a higher credit limit. Or, you’ll need to use two or more credit cards.

Plus, the interest rates charged by most credit cards are among the highest you’ll pay anywhere.

When to use a credit card for home improvements

If you must use a credit card to fund your renovations, try to apply for a card with an introductory 0% annual percentage rate (APR).

Some cards offer up to 18 months to pay back the balance at that introductory rate. This approach is only worthwhile if you can pay off your debt within that repayment period.

Like personal loans, credit cards may be acceptable in an emergency. But you shouldn’t use them for long-term financing.

Even if you have to use credit cards as a temporary solution, you can get a secured loan later to pay off the cards.

Credit cards for home improvements: Pros and cons

Credit card pros:

Quick and easy
No paperwork
No-interest options available

Credit card cons

Annual percentage rates are much higher than other financing options
Credit cards limits are often lower than home improvement budgets

What is the best home improvement loan?

The best home improvement loan will match your specific needs and your unique situation. So let’s narrow down your options with a few questions:

Do you have home equity available?

If so, you can access the lowest rates by borrowing against the equity in your home with a cash-out refinance, a home equity loan, or a home equity line of credit.

Here are a few tips for choosing between a HELOC, HEL, or cash-out refi:

Can you get a lower interest rate? If so, a cash-out refinance could save money on your current mortgage and your home improvement loan simultaneously
Are you doing a big, single project like a home remodel? Consider a simple home equity loan to tap into your equity at a low rate
Do you have a series of remodeling projects coming up? When you plan to remodel your home room by room or project by project, a home equity line of credit (HELOC) is convenient and worth the higher loan rate compared to a simple home equity loan

Are you buying a fixer upper?

If so, check out the FHA 203(k) program. This is the only loan on our list that bundles home improvement costs with your home purchase loan. Just be sure to review the guidelines with your loan officer to ensure that you understand the disbursement of fund rules.

Taking out just one mortgage to cover both needs will save you money on closing costs and is ultimately a simpler process.

Do you need funds immediately?

When you need an emergency home repair and don’t have time for a loan application, you may have to consider a personal loan or even a credit card.

Which is better?

Can you get a credit card with an introductory 0% APR? If your credit history is strong enough to qualify you for this type of card, you can use it to finance emergency repairs. But keep in mind, if you’re applying for a new credit card, it can take up to 10 business days to arrive in the mail. Later, before the 0% APR promotion expires, you can get a home equity loan or a personal loan to avoid paying the card’s variable-rate APR
Would you prefer an installment loan with a fixed rate? If so, apply for a personal loan, especially if you have excellent credit

Just remember that these options have significantly higher rates than secured loans. So you’ll want to reign in the amount you’re borrowing as much as possible and stay on top of your payments.

Home improvement loans and your credit report

Your credit score and report always matter when you’re applying for financing. That’s true for secured loans, like cash-out refinances and HELOCs, as well as personal loans and credit cards.

When you have excellent credit, you improve your chances at getting low interest rates — with or without a secured loan.

A lower credit score will increase your loan rates significantly for personal loans or credit cards. Some personal loans charge up to 35% APR to less qualified borrowers.

Some unsecured loans also require high origination fees — a few lenders charge up to 6% of the loan amount in fees.

You can always prequalify with online lenders if you’d like an estimate on your loan rates and fees.

Prequalifying shouldn’t hurt your credit score, and it’ll help you estimate your monthly payments.

Using home equity on non-home expenses

When you do a cash-out refinance, a home equity line of credit, or a home equity loan, you can use the proceeds on anything — even putting the cash into your checking account.

You could pay off credit card debt, buy a new car, or even fund a two-week vacation. But should you?

It’s your money, and you get to decide. But spending home equity on improving your home is often the best idea because you can increase the value of your home.

Spending $40,000 on a new kitchen or $20,000 on a new bathroom could add significantly to the value of your home. And that investment would be appreciated along with your home.

That said, if you’re paying tons of interest on credit card debt, using your home equity to pay that off would make sense, too.

Home improvement loans FAQ

What type of loan is best for home improvements?

The best type of loan for home improvements depends on your finances. If you have a lot of equity in your home, a HELOC or home equity loan might be best. Or, you might use a cash-out refinance for home improvements if you can also lower your interest rate or shorten your current loan term. Those without equity or refinance options might use a personal loan or credit cards to fund home improvements instead.

Should I get a personal loan for home improvements?

That depends. We’d recommend looking at your options for a refinance or home equity-based loan before using a personal loan for home improvements. That’s because interest rates on personal loans are often much higher. But if you don’t have a lot of equity to borrow from, using a personal loan for home improvements might be the right move.

What credit score is needed for a home improvement loan?

The credit score needed for a home improvement loan depends on the loan type. With an FHA 203(k) rehab loan, you likely need a 620 credit score or higher. Cash-out refinancing typically requires at least 620. If you use a HELOC or home equity loan for home improvements, you’ll need a FICO score of 660-700 or higher. For a personal loan or credit card, aim for a score in the low- to-mid 700s. These have higher interest rates than home improvement loans, but a higher credit score will help lower your rate.

What is the average interest rate on a home improvement loan?

Interest rates for home improvement loans vary a lot. While it depends on the size of the loan, a cash-out refinance often has higher rates. However, with an FHA 203(k) loan, your interest rate is likely to be close to today’s low mortgage rates. Average interest rates for other types of home improvement loans, like home equity loans and HELOCs, are higher than mortgage rates. And with a HELOC your rate is variable, so it can rise and fall throughout the loan term.

What is the best renovation loan?

If you’re buying a fixer-upper or renovating an older home, the best renovation loan might be the FHA 203(k). The 203(k) rehab loan lets you finance (or refinance) the home and renovation costs into a single loan, so you avoid paying double closing costs and interest rates. If your home is newer or higher-value, the best renovation loan is often a cash-out refinance. This lets you tap the equity in your current home — and you could refinance into a lower mortgage rate at the same time.

Is a home improvement loan tax deductible?

Home improvement loans are generally not tax-deductible*. However, if you finance your home improvement using a refinance or home equity loan, some of the costs might be tax-deductible. *Disclaimer: The Mortgage Reports does not provide tax advice. Be sure to consult a tax professional for any questions about your taxes.