Americans spend more than $400 billion each year on home improvements and repairs. That figure has grown by more than 50% since the end of the Great Recession due in large part to the fact that four-in-ten homes in this country, or roughly 55 million, were built before 1970.
With the pandemic changing housing preferences and more Baby Boomers opting to stay in their longtime homes after their kids fly the coop, the popularity of home improvement projects is sure to grow for years to come — and so is the cost of completing them.
According to the Harvard Joint Center for Housing Studies, in 2017 the median cost of a home improvement project was $1,200. Most people covered repairs with cash, but replacing an outdated HVAC system or making accessibility improvements tend to cost a lot more, meaning owners are increasingly likely to turn to home improvement loans.
“Expanding the ability of owners to pay for improvement projects over time — whether through home equity loans or lines of credit, cash-out refinances, or contractor-arranged financing — would not only generate considerable growth in the remodeling industry, but also help to preserve and modernize the nation’s aging housing stock,” wrote the authors of Harvard’s bi-annual report on home improvement spending.
Here, we outline the steps to finance your next home improvement project — and how to qualify for a home improvement loan.
Home Improvement Loans: Tap Your Home Equity With a Home Equity Loan, Home Equity Line of Credit, or a Cash-Out Refinance
Owners’ equity in their homes has been increasing for a decade. Equity has been growing even faster during the homebuying boom spurred by the coronavirus pandemic.
Homeowners tend to spend the most on home improvement in markets where home price appreciation has been strongest. Since the Great Recession that has included areas like Boston, Dallas, San Antonio, San Jose, San Francisco, and Seattle. According to Harvard’s report, “Rising prices mean growing home equity, which provides owners both the incentive and the means to undertake more and larger projects.”
Tapping into the equity you’ve built in your house is one of the most common ways to fund a home renovation project. You can do this by taking out a second mortgage in the form of a home equity loan or line of credit, or by refinancing your current mortgage and taking cash out.
Step 1 for Home Improvement Loans: Gather Your Information
All three options will require you to have good credit (meaning a FICO score of 670 or above). A good first step is to pull your credit report (you are entitled to a free report annually) and check your credit score (you can do this with your bank or via an app like Credit Karma). Just like when you applied for your purchase mortgage, next you’ll want to gather documents that verify your income, such as your W-2 and pay stubs. As with your original mortgage, for a home equity loan or refi, lenders will want to see your debt-to-income (DTI) ratio — the share of your income you spend each month on debts (mortgages, students loans, auto loans, etc) — stay below 43%. Since there are fewer Federal guidelines regarding HELOCs, you may be able to qualify with a higher DTI.
Lenders will also typically require you retain around 20% equity in your home to get any of these loans, so you’ll need to get a new appraisal to determine the home's current value and how much equity you’ve gained through appreciation as well as mortgage payments. Keep in mind that early-on most of your monthly mortgage payment goes toward interest.
Step 2 for Home Improvement Loans: Research How Much Home Equity Loans, HELOCs or Cash Out Refis Cost
These loans will have higher interest rates than your original mortgage, but lower rates than an unsecured personal loan. In October, for example, when the average rate on a 30-year fixed rate mortgage was below 3%, the average rate on a HELOC was around 4.5% and on a home equity loan it was around 5%. Closing costs, such as origination fees and appraisal fees, generally total between 2% to 5% of the loan value.
If you use the funds you get from a home equity loan or line of credit to meaningfully improve your home you may be able to deduct interest payments from your taxes. However, like a first mortgage, these loans are secured by your home, meaning your lender can foreclose and force you to sell your home if you don’t pay.
Step 3 for Home Improvement Loans: Decide Which One is Right For You
A home equity line of credit works kind of like a credit card, where your credit limit equals between 60% and 85% of your home’s value. (Though, when economic conditions are poor, lenders sometimes cap the amount borrowers can take out to 75% or 80%.)
HELOCs have adjustable rates, meaning your rate may be low to start but can change based on market conditions. That means you should only go this route if you will be able to pay off the debt quickly. Moreover, some HELOCs only require interest payments for five to ten years, which means you could go that long without chipping away at your balance. However, if you are confident you can pay in a timely manner, a HELOC can be a flexible and relatively affordable way to fund an ongoing home improvement project. The debt is revolving, which means you can borrow more as you pay off your balance.
A home equity loan, on the other hand, is an installment loan that you will repay over five to 30 years. This means you get the money up front, making this a solid option if you know exactly how much you’re spending. A home equity loan has repayment terms just like a plain-vanilla mortgage — with a fixed interest rate and monthly repayment schedule — making this route easy to understand if you’re already paying off a home loan. That’s why these loans are sometimes simply referred to as second mortgages.
Finally, with a cash-out refinance you replace your current mortgage with a new, larger one. You refinance your existing mortgage and the lender gives you the rest as cash. The funds you get from a cash-out refinance are subtracted from your equity in the home. This could be a good path if you could also lower your interest rate by refinancing or if you want to adjust your loan term to pay off your mortgage sooner (though a shorter loan combined with a higher balance, could mean much higher monthly payments).
Borrowers with poor credit may have an easier time qualifying for a cash-out refinance. However, refinancing resets the clock on your mortgage, meaning you will be paying for longer. (This is true whether you are refinancing to take out cash or lock in a lower interest rate — or both.) Unlike a home equity loan or line of credit, with a cash-out refinance you pay closing costs on the full loan amount instead of just the cash you need.
What are unsecured home repair loans?
According to the Harvard report, over 80% of home renovation spending in 2017 was on professionally done projects and 28% of professional projects were paid for with financing.
If you opt to hire a contractor for your project, it is possible they will try to sell you financing. Some remodeling professionals partner with lenders to offer personal loans with as little as 0% interest. Think of this like when a car dealer organizes financing for your car, they typically partner with a bank and are selling the loan on their behalf.
Contractors like these because people tend to spend more when financing. Per Harvard, owners who pay with savings or credit cards spend $3,300, on average. People who pay with contractor-arranged financing spend almost twice as much — $6,500 on average. (Owners who tap their equity spend even more: $7,500 if the source is a cash-out refinance and $9,300 with a home equity loan or line of credit.)
Like any personal loan, this financing is unsecured. That means you are not using your home as collateral, but can also mean a much higher interest rate. Repayment times on personal loans are also generally much shorter than on mortgages — typically one to five years. But this type of financing is convenient and does not require you to give up equity. Personal loans — contractor-arranged or otherwise — may also be the only option for newer homeowners who don’t have much equity yet but still want to undertake a home renovation project.
Home Renovation Mortgages and FHA 203(k) Loans: What to Know
Loans such as the Federal Housing Administration 203(k) rehabilitation loan or Fannie Mae HomeStyle Renovation Mortgage are designed for buying a home in need of significant work — "fixer uppers." Both provide funds for the purchases as well as a reserve for renovations, which is put into an escrow account.
FHA 203(k) loans require just a 3.5% down payment. You can borrow up to the FHA loan limit in your area ($331,760 in most places) and can include certain do-it-yourself repairs. Homestyle loans require at least 5% down. You can borrow up to the Fannie Mae loan limit ($510,400 for most of the country) and finance renovation costs up to 50% of your home’s completed appraised value. No DIY allowed.