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4 types of home renovation loans and how to choose

Yahoo Personal Finance· Getty Images
Updated 7 min read

The costs can add up quickly if your home needs repairs or major upgrades. According to the home services website Angi, the average bathroom renovation will cost $11,250, and the typical kitchen remodel cost can range from about $14,500 to over $40,000. Many homeowners turn to home renovation loans to pay for these improvements.

Understanding how home renovation loans work is essential for finding the right one for your home improvement project.

Learn more: Types of mortgage loans

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A home renovation loan — also called a home remodel loan or home improvement loan — gives homeowners access to cash to upgrade their properties. Various home improvement loans are available, each with rules and requirements.

The most common home renovation loans leverage the equity you have built in your home so you can tap your equity via the loan. This generally means you can qualify for a favorable interest rate. Still, this is a “secured loan.” With secured loans, your home is considered collateral, meaning you could lose your house to foreclosure if you default on the home improvement loan payments.

Other home renovation loans are unsecured, meaning your home is not used as collateral for the loan. Unsecured home improvement loans will often have a higher interest rate than loans that leverage your equity, but there is no risk of losing your home if you default.

Read more: Discover Bank home equity lending review

Each of the following loan options will provide you with the cash you need to make renovations or improvements to your home. The right one for you will depend on factors like the cost of your project, the amount of equity you have built in your home, and your credit score and history.

Remember that these are options for remodeling a home you already own. If you want to roll your initial mortgage and home repair costs into one loan, consider the FHA 203(k) rehab loan or options through Fannie Mae or Freddie Mac for conventional loans.

Commonly referred to as a second mortgage, a home equity loan allows you to borrow a lump sum based on the amount of equity you have built in your home. Most lenders will allow you to borrow no more than 80% of your built-up equity. For example, if your home value is $300,000 and you still owe $200,000 on your initial mortgage, you have $100,000 in home equity. Your lender will allow you to borrow no more than $80,000 (or 80% of $100,000) for your home equity loan.

Home equity loans typically have fixed interest rates, meaning you will make fixed monthly payments for the entire repayment period (which can range from five to 30 years). Your interest rate will depend on your credit history and income. Because your home is used as collateral, defaulting on a home equity loan can result in foreclosure.

Read more: What is a second mortgage, and how does it work?

Like a home equity loan, a home equity line of credit (HELOC) allows you to access the equity you have built in your home. However, instead of receiving the money as a lump sum, your HELOC works more like a credit card. You can take out money when needed, pay it back, and access more funds later. Your HELOC borrowing limit is based on the amount of equity you have built and your credit history, and like the home equity loan, most lenders limit your HELOC to 80% of your equity.

HELOCs typically have a draw period of about 10 years, when you can borrow up to the limit, pay it back, and borrow again. You may be able to extend the HELOC once the draw period ends, but if not, you will have to begin repayment at that time.

The revolving nature of the HELOC can make it a better financing option for ongoing renovations — like if you plan to renovate your bathroom this year but know you’ll be making significant improvements to your kitchen within the next few years.

HELOCs usually have variable interest rates, meaning the rates may go up or down over time. However, you only pay interest on the amount you borrow, not the full borrowing limit of the HELOC. As with a home equity loan, defaulting on a HELOC could mean the lender forecloses on your house.

Learn more: Home equity loan vs. HELOC — Which is better?

A cash-out refinance replaces your current mortgage with a new one that allows you to turn some of your equity into cash. In general, mortgage lenders will only allow you to borrow up to 80% of your home value, including your current mortgage balance plus the amount you are cashing out.

For example, let’s say you still owe $200,000 on a home worth $300,000. You could refinance your mortgage into a new loan for $240,000 (80% of the $300,000 home value) — where $200,000 of the new mortgage pays off the old mortgage, and you get $40,000 in cash to use for your home improvement project. You will now have a $240,000 mortgage to repay over the full loan term, which is usually 30 years.

A cash-out refinance can also potentially help you lower your mortgage interest rate. If you have either improved your credit or interest rates have fallen since your original mortgage, a cash-out refinance can be a way to both lower your interest rate and access money for your project. And since mortgage interest rates are typically lower than rates on home equity loans or HELOCs, this could save you money in the long run. However, mortgage rates are relatively high right now, so it might not be the best time to get a cash-out refi, especially if you got your initial mortgage when rates were much lower.

Just remember that a refinance is a type of mortgage, meaning you must pay closing costs. Generally, your closing costs will come out of the proceeds of the cash-out. This also means your lender can foreclose on your house if you default on your cash-out refinancing loan.

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Taking an unsecured personal loan for your home repairs can prevent the possibility of home foreclosure inherent in home equity loans, HELOCs, and cash-out refinance loans. Since a personal home renovation loan does not use your property as collateral, you will not risk losing your house if you default on the loan.

Lenders determine your interest rate and other loan characteristics for a personal loan entirely based on your credit history, income, and other personal factors. This means unsecured personal loans tend to have higher interest rates, even for borrowers with good or excellent credit. That’s because the lack of collateral makes the loan riskier for the lender. However, every loan and lender is different, so shopping around for the best fit is crucial.

Dig deeper: Home equity loan vs. personal loan — Which is better for home improvement?

There are several types of loans available to finance home improvement projects, and some (but not all) are types of mortgages. A home equity loan and home equity line of credit (HELOC) are second mortgages that leverage equity in your home. You’ll have two monthly mortgage payments: one on your first home loan and one on your HEL or HELOC. Cash-out refinance loans are a type of mortgage that allows you to replace your current mortgage and tap into your home equity to receive cash. Personal loans for home improvement are unsecured loans and unrelated to mortgages.

Most lenders require homeowners to have no less than 15% to 20% equity in their home to qualify for either a home equity loan or a HELOC. Lenders generally limit loan amounts to no more than 80% of the equity in the house.

The right home renovation loan depends on your specific situation and needs. A home equity loan is more likely to have a fixed interest rate and allows you to access a lump sum all at once. A HELOC offers long-term flexibility but is more likely to have a variable interest rate that could increase or decrease over time.

This article was edited by Laura Grace Tarpley.