How do home improvement loans work?


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Creating a dream home on a budget can be tricky. On one hand, renovating a home can be one of the most efficient ways to grow the value of the property. But on the other hand, the home improvement process can be infectious, leading homeowners to add more and more projects to their list.

However, even relatively small jobs, such as replacing a major appliance like a stove or dishwasher, can easily run $1000 with installation included, and balancing the price of comfort vs. the feeling of a worthwhile investment is subjective, hinging entirely on an individual’s financial goals, limits, and flexibility—not to mention funds—to plan for the future.

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Loan Options

Whether the homeowner plans to hire a professional contractor or go the DIY route, home improvement loans can go a long way towards affording greater flexibility in navigating and managing any planned upgrades or repairs.

There are pros and cons of taking on debt for home improvement projects, and homeowners have options when considering different types of loans.

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Paying for Home Improvements

Homes are investments, and most homeowners are interested in protecting that investment for their own financial security and in the interest of the value of their neighborhood.

When a neighborhood has properties in disrepair, the overall value of the area tends to decrease. Neighborhoods that have properties in good repair tend to suggest a thriving community.

Paying for home improvements with cash is the thriftiest way to go, but if a homeowner doesn’t have sufficient savings to do this, taking on debt in a responsible way can be an acceptable way to improve their home.

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What Is a Home Improvement Loan?

Home improvement loans are personal loans used to pay for home repairs or renovation projects. These are unsecured loans—meaning the house isn’t used as collateral to secure the loan. Approval is based on creditworthiness and other personal financial factors that will vary from lender to lender.

As always, it’s worth doing some research and shopping around for these types of loans, as there can be a fair amount of variability in terms and rates, depending on the amount of the loan and underwriting criteria.

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Alternatives to a Personal Loan

Homeowners who feel comfortable offering their home as collateral on a secured loan have a few options.

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1. Home Equity Loan

Home equity is the amount a home is worth compared to how much is owed on it. For example, a home valued at $100,000 with a remaining debt of $75,000 would have $25,000 in equity. As the debt is paid down, the amount of equity will increase.

Homeowners may be able to borrow against the equity they have in their home. Home equity loans are funded in a lump sum and generally have a fixed interest rate, which means a fixed monthly payment. The interest paid on this type of loan may be tax deductible as long as the funds are used to substantially improve a main residence or second home and are secured by the same.

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2. Home Equity Line of Credit (HELOC)

HELOC is similar to a home equity loan, except that the funds are not distributed in a lump sum. The amount of money that can be borrowed is still tied to the amount of equity in the home, but the borrower accesses the funds as needed.

There is generally a limited amount of time during which the funds can be accessed—this is called the draw period and is typically 10-15 years. During the draw period, only interest payments are required. After the draw period, monthly payments on the total debt will include principal and interest.

Interest rates on HELOCs are usually variable, so monthly payments will not always be the same. Tax deductibility is the same as for home equity loans.

This type of loan may be useful for those who don’t know exactly how much they’ll need for a home renovation. Funds can be drawn on as needed and can be replenished by making payments.

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3. Cash-out Refinance

cash-out refinance is a new mortgage taken out on an existing property for more than what is owed. This new mortgage replaces the existing one, part of the funds paying off the existing debt and the remainder disbursed in cash to the borrower. The new mortgage may have different terms than the old mortgage.

Homeowners may have a better financial situation then when they originally took out their mortgage, so might have some room for negotiating a better rate when refinancing. Lenders typically look at an applicant’s financial history, as well as the appraised value of the home and how long the existing mortgage has been in place.

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4. Construction Loan

A construction loan may be an option for more substantial home renovations, but a lender may need to be convinced that the value of the property is worth the investment.

There will be more paperwork involved in this type of loan because in addition to the borrower’s own financial documentation, a lender will probably want to see renovation plans, a budget, and construction schedule.

Having a reputable contractor may go a long way towards getting approval for a construction loan, as the lender may want to see the contractor’s references, proof of insurance, project specifications, and a signed contract.

Since these financing options are secured—typically the property is used as collateral—the interest rates are often lower than personal loan interest rates.

Homeowners may want to consider their current mortgage lender for loans that are tied to the equity they have in their home. Some lenders may offer lower rates for current borrowers. But shopping around to compare rates and fees is recommended.

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Home Improvement Loan Alternatives

For homeowners who may not qualify for a home improvement loan, there might still be alternatives that serve the same purpose. Some examples are home improvement grants and loans offered by the US Department of Housing and Urban Development (HUD) and funding options offered through the USDA’s Rural Housing Service.

Both of these federal agencies provide detailed information on their websites. While they are federal programs, there may also be requirements for individual states or communities.

Something to consider when looking at different types of loans is whether the rate is fixed or variable. Personal loans and home equity loans are generally fixed-rate loans, while HELOCs usually have variable rates.

A cash-out refinance can be either fixed or variable, depending on the type of mortgage loan a borrower desires. Payments on a fixed-rate loan will be the same month-to-month, while payments on a variable-rate loan will change occasionally according to the current interest rate.

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Applying for a Home Improvement Loan

For applicants whose financial history shows responsible use of credit, the process is typically straightforward: apply for the loan, receive the funds, and then get to work on those home improvements.

But that’s assuming the borrower has a solid financial picture that conforms to a lender’s standards. Approval for a loan may be affected by factors like debt-to-income ratio, credit history, and other factors.

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Home Improvement Loan Benefits

A nice benefit to home improvement loans is that they can often be assessed and subsequently approved quickly, with minimal hoops to jump through in the process—which is usually quite unlike a mortgage application experience or with a secured loan.

Before applying for any loan, a practical first step for the potential borrower might be to review their credit report, checking for mistakes or discrepancies that might negatively impact a loan application. Because personal loans are unsecured loans, an applicant’s credit rating will be a large part of what determines the interest rate they may qualify for.

Applicants who don’t have a strong credit rating or lack a credit history may want to consider applying with a co-signer or co-borrower.

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Bringing It Home

Just like buying a home, taking out a loan to improve that home should be considered from many angles. No matter what decision is made in the end, it’s wise to consider the trade-offs and responsibilities with each possible option.

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