Personal Loans , Home Equity

Can You Take Out A Loan For Home Renovation

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 14 minute read

You fell in love with your turn-of-the-century Craftsman the moment you stepped inside. Your better half will like the porch’s protection, while you’ll admire the home’s timeless walnut woodwork.

You’re glad you made the decision to purchase a vintage home, but you are under no false pretenses about its pristine condition. You and your spouse and children have been enjoying your current home, but you’ve recently come to the conclusion that you need additional room and contemporary conveniences to accommodate your expanding family.

You’ve been trying to buy a newer, larger house in the region, but the market is too competitive, and homes built after World War II lack the same appeal. Instead of starting again, you decide to complete the cinder-block basement in your present house. Though not inexpensive at around $15,000, it will be more reasonable than a larger residence.

There is, however, a catch. You wouldn’t worry about using your money for a down payment on a new home since you’d be able to get those cash back when you sold your existing home.

You know that finishing your basement will increase your home’s worth in the long term, but you shouldn’t expect to see any immediate return on your investment. The goal of this renovation, after all, is to ensure that your family may continue to reside in the same house for many years to come. You can’t get a home equity line of credit since you utilized a low-down-payment FHA loan to buy the house (HELOC).

Do you have no other choice? No, that’s not always the case. The only real requirement for an unsecured personal loan is that you pay it back on a monthly basis, so long as your credit is good enough. A big home remodeling project is a valid reason to seek a personal loan for homeowners with little or negative equity, and it may even be the more responsible choice than using the funds for a lavish trip or wedding.

Home Improvement Loans and How They Work

A home renovation loan from a provider like Credible.com is a short-term, unsecured loan designed to cover costs associated with fixing up one’s dwelling. A home renovation loan operates in the same way as a personal loan for any other lawful reason, such as paying for unexpected medical bills, paying off credit card debt, or starting a company.

There is often no difference in interest rates or other loan terms between loans used for different purposes. Instead, they are determined by the lender’s underwriting requirements, the current benchmark interest rates, and other factors that have nothing to do with the borrower’s creditworthiness, such as the borrower’s debt-to-income ratio.

Excellent credit (FICO score 720-740) borrowers can anticipate receiving personal loan offers including:

  • If there are any origination costs, they are likely to be less than 2%.
  • Low annual percentage rates (APRs ranging from 10% to 12%, including any origination cost)
  • Longer phrases (five to seven years)
  • High borrowing limits (up to and including the lender’s maximum, which is usually between $35,000 and $40,000)

To get a personal loan, a borrower has to have strong credit (FICO score of 660-680).

  • If there are any origination costs, they should be moderate (less than 4%).
  • Moderate interest rates (less than 15% APR, including any origination cost)
  • Terms that are moderate (three to five years)
  • Borrowing limitations that are moderate (variable by lender)

Borrowers with fair or damaged credit (FICO scores below 660), if they qualify at all, will likely be saddled with expensive, short-term loans.

Looking at Loan Estimates for Improvements to Your Home

It’s in your best interest to compare home renovation loan rates from several sources because every lender has their own policies and procedures. If you need assistance, using a service like Credible.com can help. Within a matter of minutes, you may get prequalified and start receiving bids from several lenders.

In most cases, checking your credit won’t hurt when you’re only doing an initial loan screener. This is because potential creditors won’t “pull” your credit report (temporarily lowering your score) unless you actually apply for credit with them. Once you’ve found the most favorable loan offer, hopefully this will be your last application.

Changing the rates and terms of an installment loan can have a significant impact throughout the life of the loan. Consider the case of needing $15,000 in home remodeling financing as an illustration. Here is how your monthly payment and total financing cost might vary depending on the annual percentage rate (APR) and length of your loan:

  • Your monthly payment will be $470.05 for 36 months at an annual percentage rate of 8%, and your total interest will be $1,921.64.
  • The interest costs alone over the 60-month period will add up to $3,248.75.
  • Your monthly payment will be $491.08 for 36 months at an annual percentage rate of 11%, and your total interest will be $2,678.91. The interest you’ll pay over the course of the 60 months will add up to $4,568.18.
  • At 14% APR, your monthly payment will be $512.66 for 36 months, and the total interest you pay will be $3,455.92. Your monthly payment during the 60-month period will be $349.02, and your interest costs will amount to $5,941.43.
  • At 17% APR, your monthly payment will be $534.79 for a duration of 36 months, and the total interest you’ll pay will be $4,252.47. Your monthly payment on a loan with a 60-month term will be $372.79, and your total interest will be $7,367.32.

Lower overall interest costs and higher but fewer monthly payments are the result of a shorter loan period, regardless of interest rates. There will be more interest paid overall, but the monthly payments will be smaller.

How to Apply for a Home Improvement Loan

Provided you stay on top of things, you should be able to finish your home renovation project well within the period of your loan. Under competent supervision, even extensive home renovations like remodeling the kitchen or adding an auxiliary housing unit may be finished in a couple of months.

The way you approach your home renovation project will determine how you spend the money you borrow for the job. There are two paths you can take:

DIY Projects: Directly Pay Home Improvement Expenses

When doing a do-it-yourself project that requires many journeys to the home improvement superstore and/or several orders placed with materials suppliers, this strategy is highly effective.

Your financing would be disbursed before you made your first purchase for the home renovation project. From this point on, you should make payments on your home improvement costs when they become due. The cost of installing a driveway, for instance, might include things like:

  • Paving equipment rental
  • Renting drainage digging tools
  • Purchasing drainage pipes or liners
  • Purchasing a variety of materials for layered surfaces

These costs, as well as any others that may crop up throughout the course of a particular project, will need to be covered by a separate withdrawal from your loan funds. If your project is quite straightforward and won’t take more than a couple of months to complete, you can probably buy all of your necessary purchases with the loan money and then start making principal payments.

Pay Vendor Bills at Project Milestones for Contractor Projects

Contractor-completed projects benefit from this strategy since they typically have big bills at significant project milestones, such as a deposit equal to 25% to 35% of the expected total cost and then a final payment for the remainder. If you’ve decided to skip the general contractor in favor of handling the subcontractors yourself, you’ll have to pay them as they start and finish their work.

To avoid any unnecessary delays, you might put off applying for a loan until after the first costs of the project have been incurred. As a result, you may spend less time paying off your debt and more time enjoying the fruits of your labor.

A full kitchen makeover, for example, might easily take 12 months, so this tactic improves the chances that your loan’s revenues will continue during the whole duration of the project. Cons include the inevitable possibility of budget overruns on a project of this scale, as well as the possibility that you won’t be able to find a lender willing to finance the full amount of your loan request.

The Advantages of Using a Personal Loan for Home Improvement

Taking out a personal loan to pay for your next home improvement project isn’t the best option, but it may work out if you’re in a need.

  1. The project may be able to pay for itself.

Nothing is certain in our world, least of all house repairs. However, certain renovations might more than compensate for themselves through increased resale value. The following are examples of home renovations that often yield a positive return on investment:

  • Kitchen renovations
  • Adding or remodeling a bathroom
  • Including a deck
  • Making energy-saving improvements, such as new windows and insulation (which also reduce homeownership costs)

Some examples of home improvements that are unlikely to generate a return on investment through a rise in the property’s value are:

  • Including an extra room
  • Putting in a sunroom Putting in an in-ground pool
  • Including a garage
  • Roof replacement (though all roofs must eventually be replaced)

Calculating the Value-Add of Your Project

The value-add of a home renovation project can be determined in one of two ways.

  • Actual vs. Estimated Sale Price. This is the difference between the actual sale price of your upgraded property and the expected sale price of an equivalent, unimproved home.
  • Purchase Price vs Sale Price. This strategy becomes less accurate over time as market factors unrelated to the improvement – such as buyer desire and current loan rates – impact resale value. In addition, if you have lived in your house long enough to complete many home improvement projects, you must account for their cumulative cost and added value.

For both cases, the second number should be subtracted from the first. When the savings are more than the cost of the renovation, you have a positive financial outcome.

  1. It is capable of covering emergency repairs.

If you’re willing to wait, you can put together enough money to complete some much-needed house improvements. Of course, not every attempt to enhance one’s dwelling is entirely optional.

You may not have the luxury of waiting until you have more money to repair or replace a major appliance or feature, such as your furnace or roof, that is on its final legs.

Repairs that are genuinely urgent may necessitate immediate payment. Depending on how much you have saved for an emergency, you may have to dip into it or use a credit card. 

Personal loan profits might be used to settle a temporary financial obligation. If you finish your loan application before your credit card statement is due, you won’t have to pay any interest on the transactions you made.

  1. It’s Beneficial to Your Monthly Cash Flow

Personal loan profits can be used to spread the expense of the project over three to five years, which is much easier on the budget than making monthly payments in full.

  1. It may be simpler, faster, and less expensive than alternatives.

A personal loan application may be completed in a matter of hours, but a first mortgage application might take several days or even weeks. A home equity line of credit (HELOC) or second mortgage has a similar application process.

Closing expenses for a home equity loan or home equity line of credit aren’t as large as they are for a first mortgage, and they may usually be included into the loan sum, but they still add up to a considerable portion of the overall cost of financing. It takes time because most home equity lenders need an appraisal and title insurance.

A personal loan application may be completed in a matter of hours, but a first mortgage application might take several days or even weeks. A home equity line of credit (HELOC) or second mortgage has a similar application process.

Closing expenses for a home equity loan or home equity line of credit aren’t as large as they are for a first mortgage, and they may usually be included into the loan sum, but they still add up to a considerable portion of the overall cost of financing. It takes time because most home equity lenders need an appraisal and title insurance.

  1. You are not bound by equity.

If you use a low-money-down loan to buy a house quickly, you may have a long way to go before your loan-to-value ratio meets the 85% level at which most home equity lenders would approve your application for a home equity loan or home equity line of credit.

Misfortune in time might also lead to equity constraints. An economic downturn in the housing market can affect anyone, even a financially stable buyer who puts down the standard 20%. If the property’s valuation drops by 20%, all of their initial equity will be lost.

It’s possible that a personal loan is your only choice for funding home improvements if you don’t have enough equity in your property to qualify for a low-interest mortgage.

Disadvantage of Using a Personal Loan for Home Improvement

These are just some of the factors to think about before deciding on a personal loan or before starting your home renovation project.

  1. It Could Affect Your Creditworthiness

Any time you open a new line of credit, you expose yourself to this danger; nevertheless, debtors with sizable outstanding sums on unsecured loans are especially vulnerable. Your credit score might take a serious knock if things go wrong with your home renovation financing. After your loan is funded, lenders may be extra cautious even if the worst case scenario doesn’t occur.

Defaulting on a home renovation loan poses the greatest threat to the borrower’s credit. If you suddenly lose your job or significant assets and are no longer able to make your monthly payments, your lender may report this to the three major consumer credit reporting bureaus. 

The negative effects of negative entries on credit reports tend to last for seven years. Debt-to-income ratios don’t have an impact on your credit score per se, but lenders favor those with ratios below 50%; for many, the threshold is 40%. Your debt-to-income ratio will almost certainly increase after opening a sizable new line of credit. This may make future borrowing plans difficult if you are currently on the edge.

  1. Interest Charges Cannot Be Avoided

Installment loans always come with some interest attached. The amortization schedule for a loan lays out the breakdown of principal and interest for each installment. You will still be responsible for paying interest on your loan, even if a windfall allows you to pay it off after just one monthly payment.

You can avoid paying any interest at all on a revolving credit line if you pay it off before your bill is due.

  1. Interest Rates Could Be Higher Than Alternatives

APRs on unsecured personal loans can be as low as 6% to 8% for borrowers who meet certain criteria, such as having a low debt-to-income ratio, making over $100,000 per year, and having a FICO credit score of 740 or above. With regards to unsecured credit options, it is a very broad spectrum. Even the most eligible candidates for credit cards often only receive a 10-12% approval rate.

Interest rates on HELOCs and home equity loans are often cheaper than on unsecured alternatives since the lender assumes far less risk when lending money to a homeowner who has equity in their house. Interest rates on home equity products for borrowers who qualify have been hovering around or around 5% since the late aughts.

  1. Your project may not be self-sustaining.

It is not necessary for a home improvement project to generate a profit in order for it to be worthwhile. Adding a sunroom to a house is a costly endeavor, but if you have good reason to assume that you will be living there permanently, you should go ahead and do it.

However, it is essential to estimate the anticipated value-add if you are counting on the increase in resale value to cover the cost of the renovation. This is especially true if you intend to quickly resell your house when the renovation is finished.

  1. Your project may turn out to be more expensive than anticipated.

All-cash projects are just as vulnerable to cost overruns and poor workmanship as those funded by individual loans. However, the risk is amplified when you have taken out a personal loan that is only just big enough to meet the project’s anticipated expenditure and have little wiggle room in your savings account to cover unexpected costs.

If you need to utilize an unsecured personal loan to complete your project, be sure to seek a sizable buffer (10% to 15% more than the total project cost) and to repay any leftover money as soon as possible. Accessing a home equity line of credit is preferable than using savings or retirement funds in times of financial need.

  1. You might not complete your project.

My wife and I just looked at a property that was larger than we required, but it was reasonably priced and had great curb appeal, so we decided to keep looking. The house appeared to be in good shape until we reached the unfinished kitchen, which had a hole the size of a double door leading to a shabby sunroom that, in turn, looked out into a structurally unstable unattached garage.

After a spring flood, the basement looked like a maze of unfinished rooms. The second story was just as bad as the first, with rooms that were too tiny and with ceilings that were too low. Up a narrow set of stairs, behind a little barred door, was what appeared to be a tiny attic.

I still can’t help but wonder what went wrong in that house. I believe it was an attempt at a flip, in which the buyer misjudged the work required to get the house in selling condition, attempted to do too much of it themselves, supplemented it with low-quality substitutes, and then gave up and listed the property at a loss.

Despite your best intentions, home renovations can end in disappointment. They are unsuccessful because, among other things:

  • Subcontractors leave incomplete work.
  • Subcontractor errors are too expensive to repair.
  • Unexpected problems develop and become too expensive to fix, or DIY initiatives are inadequately structured or managed.
  • The project’s budget surpasses predictions to the point that it is no longer financially viable.
  1. Collateral may be required.

In most cases, borrowers with excellent credit ratings are offered better terms, lower origination costs, and lower interest rates on unsecured personal loans.

Poor credit borrowers do not do well in the lending industry. Lenders that are willing to issue personal loans typically need some form of collateral, such as the title to a car or recreational vehicle, to ensure that they will be repaid. The lender may take action to seize collateral if the loan falls into substantial default, which typically occurs after 90 days of nonpayment.

Bottom Line

The astute reader may have seen a gap in the aforementioned potential solutions. FHA 203(k) rehabilitation loans don’t seem to be listed anywhere. It’s true that 203k loans may (and frequently are) used to finance renovations to existing homes.

However, its intended use is to fund the acquisition and renovation of run-down properties, which is a far more ambitious (and expensive) endeavor than can be supported by a standard unsecured personal loan.

If you’re in the market for a home that needs a lot of work, you should check into the 203k loan program and, if eligible, give it some serious thought. Years ago, if my then-wife and I had been willing to take a huge risk and buy that strange, unfinished house, we would have done so.

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