If you’re looking for the best way to pay for your renovation, there’s every chance that you’re confused about what your options are.
In fact, we’ll take a guess that you’ve been told you should look into getting a ‘home improvement loan,’ you’ve spent time reading all about them on Google, and now you have even less clarity on the best way to pay for your project.
You see, the definition of a home improvement loan is pretty vague, and that’s where the problem starts.
Home improvement loans are often just rebranded unsecured personal loans or credit cards
These are, for most people, the best way to fund home improvements. But most often, there’s actually a greater likelihood that the loan you’re looking at is really just a personal loan or credit card that’s being marketed as a way to finance a renovation.
They have high interest rates, and when you factor in their shorter terms of 5 to 10 years, the monthly payments will almost certainly end up being crazily high.
And we’ll just come straight out and say it…you probably shouldn’t use these to pay for your home renovation project.
We’ll even go so far as to say that using a high-interest rate unsecured personal loan or credit card is one of the dumbest things homeowners do when paying for a renovation.
For sure, there are cases where they’re a decent option, such as when you only need to borrow a small amount of money over a short period of time.
But for the most part, you will have better options, and in this guide, we’ll walk you through the reasons why you shouldn’t use a personal loan for home improvement work, as well as looking at the options that are available to you.
1. High Interest Rates
Personal loans are unsecured, and this means that they come with a much higher interest rate than secured loans (such as home equity loans) that use your property as collateral.
And we’re not just talking a little bit higher.
You’ll usually end up paying a rate of somewhere between 8% and 15% on a personal loan, or even higher on a credit card.
In comparison, a RenoFi Home Equity Loan has rates nearly as low as what you would get with a first mortgage.
And in the event that you do see a lower rate advertised, don’t forget that this is usually the best possible rate that most homeowners actually can’t qualify for.
You see, the more risk your borrowing poses to a lender, the more interest you’ll pay. They want a bigger reward in return for taking a risk on you. Since there is no collateral, that’s the highest risk lending there is.
Many personal loans also come with an origination fee of between 1% and 6%, adding further costs that you might not have anticipated.
A higher interest rate results in higher monthly payments, meaning that your home improvement project that’s financed with a personal loan will cost more when compared to the alternatives.
2. Shorter Payback Period
The repayment term on a personal loan will most likely be somewhere between 5 and ten years.
In comparison, a home renovation loan commonly offers a payback period of between 20 and 30 years.
A shorter repayment term means higher monthly payments, with excessive late fees if you miss a payment.
Combine a higher interest rate with a shorter payback period and it becomes pretty clear that personal loans aren’t the best way to finance a renovation for homeowners seeking a low monthly payment.
3. Much Less Borrowing Power
Renovations can be expensive, and it’s not uncommon to need to borrow $100,000 or more to undertake your full wishlist.
But whilst there may appear to be options out there that will let you borrow this amount on a personal loan, the reality is that most only go to $25k to $35k.
In fact, very few borrowers will actually qualify for a personal loan that goes anywhere close to $100k, with lending criteria based strictly on your income and credit score.
This means that it’s unlikely that you’ll be able to borrow what you need to complete the renovations you want to carry out unless you finance your project in a different way.
Now, on the other hand, the average RenoFi loan is $175,000, with loan amounts from $20k to $500k and the ability to borrow up to 90% of your property’s after renovation value.
To put it simply, if you’re going to tackle a renovation project, choose a financing option that doesn’t limit you from getting everything you really want.
And this is rarely a personal loan or credit card.
4. Interest Isn’t Tax-Deductible
If you use a home equity loan to pay for your renovation (on the condition that it classifies as a substantial improvement; one that adds value, prolongs its useful life or adapts a home for a new use), then the interest paid on this is tax-deductible, so long as your loan amount doesn’t exceed $750k for married couples or $375k for a single borrower.
But the interest paid on a personal loan is not tax-deductible.
If you’re taking out a sizable loan to pay for an addition (or, for example, financing an ADU), these tax deductions can add up, meaning it’s even more important to carefully consider your options.
So Then, Why Do People Use Personal Loans to Pay for Renovations?
While we don’t recommend personal loans as the right way to pay for home improvements for most homeowners, there are times when they’re the best-fit solution.
But often, they’re chosen without realizing that better products might exist.
Here are some of the more common reasons why they’re used:
If You Only Need to Borrow a Small Amount
If you only need to borrow a small amount of money to fund your home improvement project (either because you’re paying most of it with cash or aren’t carrying out extensive work), then a personal loan may well be the best option.
As an example, the minimum you can borrow with a RenoFi loan is $20k.
If you only need a few thousand dollars, lower borrowing power and a shorter payback period won’t stand in your way the same as would on a larger project.
They're Fast & Simple to Secure
Getting approved for a personal loan and getting the cash is quick, as well as being pretty simple to secure, even if you have a low credit score.
You won’t need to provide collateral, as they’re unsecured, and it’s not unusual for the whole process to take just a few days.
Again, this makes them an appealing option for smaller projects or homeowners who need the money immediately.
There's a Misconception That Personal Loans are the Only Option if You Have No Equity in Your Home
It’s not uncommon for homeowners who have recently purchased their home to assume that a personal loan is the only way to finance a home improvement project because they have little to no equity in the property.
And while this may make it difficult to borrow sufficiently with a home equity loan, home equity line of credit or a cash-out refinance, there are options available.
Home renovation loans, as an example, allow you to borrow based on the future value of your home after work has been completed, significantly increasing the amount you can borrow and helping to make your wishlist a reality.
In fact, choose a RenoFi loan and this can increase borrowing power by more than 12x whilst also ensuring that the lowest possible interest rate is secured.
Just because you haven’t built up equity, it doesn’t mean you have to scale back your plans.
Justin Goldman, Co-Founder & CEO of RenoFi addresses this problem, highlighting that:
“The two most popular existing financial products used to finance home renovations - Cash-Out Refinance or a Home Equity Loan - are not designed for renovations, and while they can work well for long-term homeowners (those who’ve been in their homes 10+ years), they don’t serve recent homebuyers who haven’t yet built up equity.”
Just look at how even the most basic renovations are out of reach for years to come when relying on equity as your only lever:
The good news is that alternatives do exist, even if you haven’t built up equity in your home.
Alternatives to Personal Loans to Finance Home Renovations
Most of the time, you shouldn’t use a costly personal loan to pay for your remodel.
But what are your other options and how do they stack up?
Home Renovation Loans
Given that a home renovation loan lets you borrow based on the after renovation value of your property, they’re the most attractive option for many projects.
You see, renovations typically mean that your house will increase in value, and a good average to work on here is that for every $100k spent, homeowners will see an increase in their property’s value by $75k.
And this method of financing allows you to access this additional value upfront, to help you to pay for the project.
But there is more than one type of home renovation loan…
A RenoFi Loan
Take out a RenoFi loan and you’ll benefit from borrowing power that’s based on your home’s after renovation value, without the need to refinance your first mortgage.
To put it simply, this is the perfect way to borrow the most money at the lowest possible rate.
These loans also have the low fees, a flexible term of up to 20 years, and the same low interest rates as any home equity loan
Check out this illustration to help you understand how a RenoFi loan can help you to borrow the money you need to finance your entire renovation wishlist:
These loans were created specifically to solve a problem that homeowners were facing, and offer a purpose-built product to help finance renovations as cost-effectively as possible.
A Construction Loan
Many homeowners are wrongly pointed in the direction of a construction loan to pay for home improvements. And this is usually because they let you borrow based on the after renovation value.
But this type of loan wasn’t purpose-built for renovations, rather for ground-up construction. And this means that they come with a stringent set of requirements that create a whole load of additional work for both the homeowner and contractor.
You will need to refinance your first mortgage if you take out a construction loan, you’ll face closing costs based on the new value of your mortgage and your renovation costs (as well as higher lenders fees), and have to do a whole load more work for everyone, with draw schedules, inspections and more needed.
These things mean that we’re the first to tell you that you shouldn’t use a construction loan for renovations, but it’s not just us who feel this way.
In fact, some contractors will even refuse to work with them because of the extra time and expense they involve.
Construction loans are a one-size-fits-all solution, and they’re just not set up with renovations in mind.
That said, they’re still better-suited than personal loans and credit cards for most people.
Government-Backed Renovation Loans
There are two types of construction loans that are backed by government agencies:
And, like RenoFi loans and standard construction loans, they’ll both allow you to borrow based on the after renovation value of your home.
With a Fannie Mae HomeStyle loan, you’ll be able to borrow up to 95% of the future value, and with an FHA 203k, it’s 96.5%.
Another attraction of these government-backed loans is that they’re more lenient than other options when it comes to criteria like your credit score.
That said, both of these require you to refinance your first mortgage and come with higher interest rates than construction loans through a private bank, and many contractors will refuse to work with these loans due to the headaches involved with the inspections and disbursement schedule.
You will also need to pay typical closing costs because you are refinancing, PLUS the extra costs associated with these types of loans, making it one of the most expensive ways of borrowing on the market from a fee perspective.
If you have built up equity in your home, a cash-out refinance will allow you to refinance your first mortgage and release some of this.
The funds that are released can then be used to finance your renovation.
But, unlike a home renovation loan, the amount that you can borrow is based upon your home’s current value, and this is typically maxed out at 80%.
With a cash-out refinance, your borrowing power will be significantly less than alternatives, and you may also need to change your mortgage provider, potentially losing any low-interest rate that you’re locked into.
Add to this the fact that you’ll also be paying closing costs and potentially a higher rate than other financing options and it’s pretty easy to see why most homeowners shouldn’t use a cash-out refinance for renovations.
Home Equity Loan or Home Equity Line of Credit
It’s not uncommon for homeowners to use the equity that they’ve built up to pay for home improvement work.
But, the reality is that it takes years to build up equity to a level that can finance your whole renovation wishlist, and that means that this sort of financing isn’t best-suited to people who have recently bought their house.
Equity is usually released using a:
- Home equity loan
- Home equity line of credit (HELOC)
An equity loan lets you borrow a fixed amount of cash and repay it on an agreed schedule, whereas a HELOC provides you with a revolving line of credit (up to a set limit).
While those who have lived in their home for some time and have built up a sizeable amount of equity may be able to fully fund their renovation project with this type of borrowing, most homeowners will find that their borrowing power is limited, resulting in a gap between this and the cost of the renovations you want to carry out.
Paying for home improvements with cash means you don’t face the costs of interest or fees.
And while this sounds ideal, don’t forget that it can take years to save up sufficient funds to cover the cost of the projects that you want to undertake.
During this time, you could have been enjoying the improvements to your home and making affordable repayments every month, rather than making do and dreaming of one day having your forever home complete.
There’s no denying that cash is the cheapest way to finance any sort of renovation project, big or small, but the time it takes to save up enough funds usually means that it’s not a viable option.
Forget Personal Loans & Speak to RenoFi
By now, hopefully, you’ve realized that using personal loans or a credit card to pay for home improvements isn’t the smartest move and can result in high monthly payments and a lack of borrowing power.
In fact, unless you only need to borrow a small amount of money (in which case, they might be your best option), you’ll want to consider an alternative way of financing your project.
And, in many cases, that could be a RenoFi loan.
A RenoFi loan stands out against other financing options and can help you to borrow the money you need for your project without the need to refinance your current mortgage, all while benefiting from lower fees, and being able to choose your own term of between 10 and 20 years.
Chat with us today and we’ll help you to finance your home improvements the right way!