Home equity loan vs. home improvement loan: Which is better for a renovation?

So, you’re dreaming of that perfect kitchen or bathroom remodel or turning your attic into a cozy home office. But remodeling a home can be pricey, with the average cost ranging from $20,000 to $100,000, depending on the size of the room, the quality of the materials, and the extent of the project. Rather than dig into savings, you’re decide to  borrow — and you stumble across two options: home equity loans and home improvement loans.

While they sound alike, they’re actually quite different. One is like a second mortgage. The other is sort of a specific personal loan on steroids.

Let’s dive into what sets them home equity loans and home improvement loans apart, and how to choose the right one for your needs.

What is a home equity loan?

A home equity loan allows borrowers to convert all or part of their homeownership stake into ready cash for short and long-term expenses. Home equity is the part of your house you own outright (the overall worth of the place, minus the mortgage).

Most lenders will let you borrow up to 85 percent of your home’s value. You go through an application process similar to applying for a mortgage. If approved, you get a lump sum of cash in return for the equity you are taking out. Then, you repay the loan with a fixed monthly payment over 5 to 30 years.

While homeowners can use them for anything, one of the most popular uses for home equity loans is, in fact, renovations. However, there are a few things to be cautious about before tapping into your home equity.

In the first place, you’re turning an asset into an obligation – exchanging something you own for something you owe. And the stakes are higher with this new bill. Because your home secures the loan, there’s a risk you could lose your house if you don’t keep up with the monthly payments.

“You have to weigh out the pros and cons of what that loan creates for you because you are creating another payment, you are creating more debt, and you’re eating into the home equity of your property,” says Sean Uyehara, area manager at Geneva Financial, a Las Vegas-based mortgage lender. “Does that put you in a better financial position today or potentially worse off?”

What is a home improvement loan?

A home improvement loan — true to its name — provides financing for upgrading, repairing or enhancing your home. It has a fixed interest rate, and you typically pay off the loan in over one to seven years. Unlike a home equity loan, your home isn’t on the line if you can’t pay it back.

“It’s not collateralized, so you can’t sell anything to pay that off unless you sell your house, take the proceeds of the house and pay off the home improvement loan,” says Stephanie Kizy, managing partner/lending advisor at Pro Mortgage Funding, an independent mortgage broker based in Michigan.

Since the loan is unsecured, your creditworthiness and financial profile will determine your approval.

If you’re thinking this sounds exactly like a personal loan — you’re right. A home improvement loan “is just a personal loan that is of a size that would allow someone to do a renovation project, which is one of the largest purchases that one would make,” says Laura Lynch, certified financial planner and founder of the Tiny House Adviser, a firm that provides financial advice for the tiny house community. “It’s part marketing and part ballooning up the size of the loan a person can take unsecured in order to do that type of project.”

Should you choose a home equity loan or a home improvement loan?

Choosing between a home equity loan and a home improvement loan depends on your needs, your finances and your tolerance for risk.

When should I get a home equity loan?

The borrowers best positioned to take out home equity loans have built significant equity by owning their homes for many years, “having paid off the original loan amount or bought it with cash,” says Lynch.

A home equity stake is “a hugely valuable asset,” says Jake Northrup, founder and lead financial planner at Experience Your Wealth, a digital financial planning firm specializing in young families. A home equity loan enables you to leverage the ownership you’ve built in your property for remodels, repairs or even a down payment on another house. Obviously, the bigger your stake, the more money you can borrow (though your credit score and other financials play a role too).

In addition, home equity loans are attractive because their interest rates are typically much lower than personal loans and other forms of consumer debt (closer to mortgage rates, they’re averaging around 8.7 percent right now). If you’re using the loan to fix up your home, you might also be eligible for a tax deduction: Those who itemize on their tax returns can deduct home equity loan interest, provided the funds are going to repair or improve the residence.

But remember that your home is collateral, and you risk losing it if you miss your payments. And given the size of these loans, those payments can be considerable. “Can you swing another $500, $600 a month in payments right now with your current debt?” asks Uyehara. “A lot of people might not be thinking about that. They’re just focused on the fact that, ‘Hey, I can have a beautiful kitchen or a bathroom …when I come home and it looks great.’ But is that the smartest financial decision to make in today’s economy?”

When should I get a home improvement loan?

A home improvement loan can be ideal for people who don’t have significant equity in their homes — or who don’t want to tap it, for whatever reason. Approval depends on your creditworthiness and financial profile rather than on a full underwriting procedure, and the process is usually quicker. That’s another plus for the home improvement loan, especially if you need the money for an urgent repair: The funds can be forthcoming in days, rather than weeks, as with home equity loans.

But be prepared for higher interest rates, even if you have excellent credit. Unsecured loans are always more expensive, because there’s nothing backing the debt. Home improvement loans’ rates can have a huge range, currently from around 7.5 percent to 35 percent.

Your credit score is a key factor here. “You want to have better credit, good or excellent credit in order to get a decent rate,” says Lynch. “Interest rates being what they are, most people don’t want to have a [home improvement] loan with bad credit because the interest rate is going to be really burdensome.”

Personal loans also tend to be much shorter, typically running seven years, though some can be as long as 12 years. That can be good if you don’t want to carry debt for decades. But remember, shorter repayment terms can also mean higher monthly payments.

Bottom line on home equity vs. home improvement loans

If you own a substantial part of your home outright and need a substantial sum (upper five figures to six figures) for major renovations, a home equity loan could be the way to go. Akin to a second mortgage, it’ll provide you with a longer repayment term and a lower interest rate. Its cost of borrowing gets even cheaper if you can deduct the interest on your tax return.

However, a home improvement loan might be a better fit if you need funds quickly; prefer not to put your home at risk; or plan to sell soon after renovations (if you had a home equity loan, you’d have to settle it immediately, cutting into your proceeds). The application is a lot less onerous and probably less expensive, as you won’t have to cover appraisals and other closing costs. But odds are you’ll pay a higher interest rate; given this expense and the shorter term, a home improvement loan might be better for lower-end projects.

Neither tool is perfect, of course. “Debt comes with trade-offs,” says Kizy. “Sometimes, we can use a home improvement project to increase the value of a home and increase our enjoyment of a home. But it does provide additional stress.” Understanding the pros and cons of each option, though, can alleviate a lot of that stress.

FAQ

• Is it wise to use home equity for home improvements?

  Using your equity for home improvements can be a smart move — if the renovations will substantially add value to your property and improve its marketability. If they do, borrowing against your ownership stake becomes an investment, one that’ll make that stake even more valuable down the road.  However, using home equity means you’re depleting your equity in the short term, and adding to your debt load.

• What are the alternatives to home equity/home improvement loans?

  • A home equity line of credit (HELOC) is the home equity loan’s variable-rate cousin. It’s based on similar criteria, but you can withdraw funds gradually, repay them, and borrow again, for a set period. You only pay interest on what you withdraw.
  • For smaller projects, you could use a 0% APR credit card. This tool works mainly if you can pay the balance off within the promotional-rate period, generally around two years.
  • A cash-out refinance allows you to borrow more than what is owed on your current mortgage, based on your equity stake; you pocket the difference in cash. You’ll have one debt instead of two. Refi interest rates are lower, closer to prevailing purchase mortgage rates.

• What is the monthly payment on a $50,000 home equity loan?

  The exact payment amount can vary based on the interest rate and loan term specifics. For a $50,000 home equity loan with a 10-year term and an 8.60 percent interest rate, you’ll pay $623 for example. A home equity loan payoff calculator can help you do the math for different scenarios.