Your equity and the size of your project can help you choose
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If you’re a homeowner looking to make repairs or upgrades to your home, you might face a common challenge: where to get the money. Two options you might consider are a home equity loan and a home improvement loan.
While their names are similar, a home equity loan and a home improvement loan are very different. A home equity loan is a secured loan backed by your home equity.1 A home improvement loan is an unsecured personal loan.2 Home equity loans have longer terms and grant higher loan amounts than home improvement loans. As a result, home equity loans are suited to bigger projects, while home improvement loans are best for small projects.
Both home equity loans and home improvement loans are available from banks, credit unions, and other financial institutions that cater to homeowners.
| HOME EQUITY LOAN | HOME IMPROVEMENT LOAN | |
|---|---|---|
| SECURED OR UNSECURED | Secured on home equity | Unsecured |
| LOAN TERM | Typically 5 to 20 years | Typically 2 to 5 years |
| INTEREST RATE | Fixed | Fixed |
| APPRAISAL REQUIRED | Yes | Usually not |
| CLOSING COSTS | Yes | No |
| WAIT TIME FOR APPROVAL | A month or more | A few days |
| LOAN AMOUNT | Typically up to 80% of equity | $5,000 to $20,000 |
One major difference between a home equity loan and a home improvement loan is that the former is secured by your home’s equity, while the latter is not. The equity in your home is the difference between the value of your home and your remaining mortgage balance. For instance, if your home is valued at $500,000 and you owe $300,000 on your mortgage, your equity is $200,000.
When you take out a home equity loan, your equity is the collateral for the loan. If you fail to make the required payments, the lender may foreclose on the loan and seize your home. A home improvement loan is an unsecured personal loan. If you default on the loan, the lender can’t seize your home.3 Instead, it may begin debt collection, make negative filings on your credit report, and file a lawsuit against you.4
Because home equity loans are secured, they are less risky for lenders than home improvement loans. Accordingly, home equity loans have longer terms and lower interest rates than home improvement loans.2 Home equity loans typically have a term of five to 20 years but occasionally extend to 30 years.5 Most home improvement loans have a term of two to five years, but some lenders will provide up to 10 years.62
Another difference between home equity loans and home improvement loans is the loan amount. Generally, you can borrow much more under a home equity loan.
When you take out this type of loan, the amount you borrow is a percentage of your home equity. The percentage varies by lender. Many lenders won’t lend more than 80% of your equity, but some will fund up to 100%.37
When you apply for a loan, the lender considers your equity and your loan-to-value (LTV) ratio, which is your remaining mortgage balance divided by the value of your home. For example, if your home is worth $500,000 and you owe $200,000 on your mortgage, your equity is $300,000, and your LTV ratio is 40%. If the lender will finance up to 80% of your equity, you can borrow up to $240,000 (80% of $300,000).
As your LTV ratio increases, the interest rate charged by the lender also rises.8
If you apply for an unsecured home improvement loan, the maximum amount you can borrow might be low, such as $20,000.6 However, the lender will consider your credit history, and outstanding debts, including your mortgage to ensure you can repay the loan. Home improvement loans that are secured by your home, which are similar to equity loans, allow for a larger loan amount but consider your home’s value and existing mortgage as well as your credit profile. Some lenders won’t provide a loan unless the value of your home exceeds your outstanding mortgage.
A home equity loan is more time-consuming and difficult to obtain than a home improvement loan. When you apply for a home equity loan, your application may be reviewed by multiple parties, including a loan processor and a loan underwriter. The lender may order documentation from outside service providers such as appraisers and title companies.
This process can take a month or more.9 In contrast, you can apply for a home improvement loan and receive a response in a matter of days.10
A home equity loan involves closing costs, while a home improvement loan generally doesn’t.2 When you take out a home equity loan, the amount you pay for closing costs is typically between 2% and 5% of the loan amount. This means that if you borrow $100,000, your closing costs will likely range between $2,000 and $5,000. Closing costs include things such as the application fee, the appraisal fee, and the cost of the title search.11
If you’re looking to make improvements to your home, which type of loan should you get: a home equity loan or a home improvement loan?
Which one of these types of loans works best for you depends on the equity you have in your home, the size of your project, and how soon you need the funds.
A home improvement loan may make sense when your project is small, you lack sufficient equity to get a home equity loan, or you need the funds right away. For instance, you might consider a home improvement loan if you need $10,000 to update a bathroom. A home equity loan may be a better option when your project is sizable (such as a $50,000 home remodel), you have adequate equity in your home, and you can wait a month or so for the funds.
A home equity loan is secured by the equity in your home. A home improvement loan is an unsecured personal loan.
A home equity loan generally has a higher loan amount, a longer term, a lower interest rate, and takes longer to approve than a home improvement loan. Home improvement loans are best for small projects, while home equity loans are better suited to large projects.
Yes, in most cases, the IRS allows limited deductions on interest paid on home equity loans. For instance, interest on a home equity loan used to build an addition to an existing home is typically deductible, while interest on the same kind of loan used to pay personal living expenses, such as credit card debts, is not.12
Because home improvement loans are unsecured personal loans, you generally won’t be able to deduct the interest you pay on your taxes. The main exception is if you can prove to the IRS that you used part or all of the home improvement loan for a business purpose. Consult with a tax professional before seeking this type of tax break.
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Article Link: https://www.thebalancemoney.com/home-equity-loan-vs-home-improvement-loan-what-s-the-difference-5322892
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