Personal loans are just one way that homeowners fund renovations and improvement upgrades to their home. When owners have enough equity in a property, they might opt for a home improvement loan or a home equity line of credit. When looking at a home improvement loan vs. a home equity line of credit, the main difference is the type of loan terms and arrangement. Loans are designed to offer a lump sum payment up front, while lines of credit allow the owner to withdraw smaller sums of money as improvement projects evolve.
What is a Home Equity Line of Credit?
Often abbreviated as HELOC, it allows you to access the equity difference between the loan and total value of your home. Say, for instance, that you bought a home for $200,000 a few years ago. At the time, you put 10% down on the mortgage, leaving $180,000 on the loan.
Over the past few years, you paid off another $30,000 of the principal balance. You now have $50,000 in equity. Thanks to redevelopment efforts in the community and the opening of a few new attractions nearby, the value of your home also went up to $250,000 during those years. In this scenario, the equity for your home is now closer to $100,000.
A home equity line of credit allows you to borrow money against that $100,000 at up to 85% of the total. The exact percentage depends on your credit history and several other factors. However, instead of receiving all the funding at once, you would have access to an open credit line. This allows you to withdraw money over a period of time and repay the balance according to the terms of the agreement. The specific repayment terms will depend on your lender.
Home improvement loans are a little more flexible in how you source the collateral to get them. You can get a loan that uses your home as collateral, much like HELOCs. However, there are also short-term loans that often do not require collateral at all.
Home Equity Loans. When most people refer to a home improvement loan, they mean loans that access the calculated profit-value of a home, just as illustrated for HELOCs. After assessing the value of the loan, the lender issues a lump-sum loan payment that is up to 85% of the total. Once again, the exact percentage you may borrow depends on your credit history and other factors.
Personal Loans. Building equity takes time and money. If you just bought your home, you probably have very little of either. One way to work around this is to apply for a personal loan. This is much like any other loan but could potentially involve no collateral. It typically has a fixed term, higher interest rate, and higher monthly installment amount.
Lending institutions can decide their own terms when it comes to HELOCs and home improvement loans. Still, there are some standard trends consumers have come to expect when comparing HELOC to home improvement loans:
Like most lines of credit, the interest rate on the HELOC can be adjustable. This is great when market rates are low, but can increase unexpectedly when the market changes. Some lenders do allow homeowners to convert to a fixed-interest agreement later on. In contrast, home improvement loans tend to have fixed Annual Percentage Rates (APRs).
Some homeowners compare HELOCs to construction loans. One reason for this is the interest-only payments that you make on your withdrawals while you’re still completing renovations. In contrast, when you take out a traditional loan, you make principal and interest payments together.
Interest-only payments are especially attractive when you find that the bank charges you interest on the amount withdrawn, not the full limit of your credit line. Home improvement loans are a little different in that you pay interest on the total principal owed, regardless of when and how much you use it.
HELOCs can often be used and reused again as long as the account is kept active and in good standing. Home improvement loans have a predetermined end date. Getting another loan requires applying again after successfully paying off the first one.
No form of credit based on home equity is objectively better than the other. It all comes down to your personal finances and what best suits your situation. If your family operates on a strict budget and you need to know your exact payment every month, then an improvement loan may make more sense for you. The monthly payments do not change throughout the life of the loan. It also works well if you already have enough disposable income to repay the loan while you build.
Home equity lines give owners time to save while they build so that they can repay the loan later. While it does come with the added risk of the interest rate potentially changing, you might be able to convert to fixed interest rates before the principal payments are due. HELOC also makes sense if you use it to create income-generating changes to the property, such as finishing the basement to use as a vacation rental or selling the home altogether.
Most finance gurus discourage homeowners from taking out HELOCs and home improvement loans unless they plan to use it to add value to their existing home. However, there are other excellent reasons to consider HELOCs. Some people take out these second mortgages on their homes to start a business, fund a college degree, or purchase an investment property. In contrast, home improvement loans tend to be specifically for home renovations. Be sure to confirm usage restrictions with your bank.
Credit based on home equity is the best bet for home improvement financing. Personal loans are nonetheless a good alternative when you do not qualify for either home equity credit types. Home equity loans are generally much harder to qualify for than personal loans.
Personal loans also take less time to fund, so if you need to do some renovations in a pinch, this option could work for you. One instance where you might find yourself in this position is after your home suffers damage that is not covered by your home insurance policy.
Finally, because the terms for personal loans are shorter, the monthly repayment value tends to be higher. Ensure you have room in your monthly budget to repay the loan on time and in full. If your finances don’t meet this criterion, consider holding it off until you clear some space in your budget.
Taking out a any loan is a serious decision. While it comes with many benefits, it’s only natural that you should have questions before you make a move that involves your home. With multiple options available, you may need some advice and insight to figure out which loan meets your specific needs. Taking the time to do your research and conducting a thorough personal evaluation is the best way to ensure you make a solid decision.