4 reasons why you shouldn't use an unsecured home improvement loan

When it comes to financing a home remodel, it’s perhaps no surprise that many homeowners find themselves confused as to what their best option is.

After all, while a home equity loan or a cash-out refinance has traditionally been used as a way to pay for home improvements, the reality is that these aren’t the only available options, and making the wrong choice can mean expensive monthly payments, reduced borrowing power, or both.

But perhaps the most confusion comes from the widespread availability of ‘home improvement loans,’ which are often high-interest unsecured personal loans marketed toward people who are looking to borrow to pay for renovations. This isn’t always clear and many homeowners, especially those who have not built up equity in their home, take these loans out without knowing that alternatives exist.

And we’ll come straight out and say it; most homeowners shouldn’t be using unsecured home improvement loans to pay for their renovation project, and if this is a financing option that you’ve been considering, keep reading.

In this guide we’re going to dive deep into the reasons why this is the case and take a look at the alternatives that you should be considering (including RenoFi Loans, a new type of renovation financing that lets you borrow based on your homes after renovation value).

Specifically, we’ll take a look at:

A Quick Introduction To Home Improvement Loans

First, let’s take a look at what’s known as a home improvement loan and help you to make sense of the confusion that often surrounds them.

On one hand, the term is often used to refer to pretty much any type of financing that’s used to pay for home improvement projects. But on the other, it’s not uncommon for this to be used as a way for banks to market high-interest unsecured personal loans toward those who are looking to borrow to pay for renovations.

Despite what you might be led to believe, a home improvement loan isn’t a specialist financial product in the same way as a student loan or a mortgage is, as an example.

But one of the surefire signs that the home improvement loan you’ve been offered by your bank is really just a personal loan is that it doesn’t use your property as collateral. In other words, it’s an unsecured loan.

That’s not to say that an unsecured personal loan isn’t right for everyone, but the reality is that there’s only a few instances when these are going to be your best option (we’ll look at these below).

You just need to understand the reasons why this is and what your alternatives are if you’ve been considering this type of loan to pay for home improvements.

Secured vs Unsecured Home Improvement Loans

Secured home improvement loans use your home as collateral. This means that if for any reason you are unable to keep up with your monthly payments, a lender is able to reclaim any outstanding balance by selling the property.

Securing the loan against the property gives the lender security and lessens their level of risk, often resulting in lower interest rates or higher borrowing power to reflect this.

Unsecured home improvement loans, on the other hand, are not secured against your property and, therefore, pose a greater risk to lenders. If you default on the loan, your home cannot be sold to repay the debt.

Given that unsecured loans are not backed by collateral, lenders will make their approval decision based on your credit score, income and the loan amount in order to assess the level of risk involved. This means that lending criteria is often strict and it can be difficult to get approval if you have a poor credit score or other outstanding debts.

A Side-by Side-Comparison

Here’s how secured and unsecured loans stack up against each other:

The Different Types of Unsecured Home Improvement Loans

Most renovation financing options are secured against your home, but two methods that can often be advertised as home improvement loans are unsecured:

Personal Loans

To make it clear again, what you’ll often see advertised as a ‘home improvement loan’ is really an unsecured personal loan, and for this reason, it’s important that you take the time to fully understand any financing option that you’re considering.

Personal loans are often used to finance renovations because they do not require homeowners to have built up equity and because of the speed and ease at which funds can be obtained, but these come at a cost both in terms of higher interest rates and much lower borrowing power than alternatives.

Most homeowners shouldn’t use personal loans to pay for renovation work, with a few exceptions that we’ll touch on below.

Credit Cards

Credit cards are another form of unsecured financing that is sometimes used to pay for home improvements and the same drawbacks of personal loans apply.

The interest rates on a credit card will usually be even higher than on personal loans, making the total cost of a renovation even more expensive.

And while credit cards are unlikely to be advertised as ‘home improvement loans,’ it’s common to see lenders recommending them to be used in this way.

4 Reasons Not To Use Unsecured Home Improvement Loans To Pay For Renovations

For most homeowners, an unsecured home improvement loan isn’t going to be the best way to pay for renovations.

But why is that the case?

Here are 4 reasons why you should consider an alternative:

1. High interest rates

Unsecured loans mean an increased level of risk for lenders as there’s no collateral used, and greater risk means that you’ll pay a higher interest rate compared to secured financing options such as home equity loans.

And by high interest rates, we mean noticeably higher. We’re talking anywhere between 8% and 15% on a personal loan or higher for a credit card and even when you see lower rates advertised (this will be the best that’s available, not that you’ll be able to get). In comparison, a RenoFi Loan has fixed rates starting from 4.12%.

A higher interest rate means higher monthly payments.

And here’s how different interest rates change the monthly payments borrowing $50k over 10 years.

That’s $200 higher every month with the only difference being a higher interest rate.

But a higher interest rate isn’t the only thing that pushes up your monthly payments with these loans.

2. Shorter payback period

while a home renovation loan will typically offer a payback period of between 20 and 30 years, with an unsecured home improvement loan, you can expect this to be between 5 and 10 years.

And again, a shorter payback period means higher monthly payments.

Using the same example as above, let’s show the difference between 5, 10 and 20 year payback periods on monthly payments.

Shorter payback periods mean higher monthly payments, and when combined with high interest rates this means that these will be sky high. Ouch!

Let’s say an alternative gave you an interest rate of 5% and a payback period of 20 years; your monthly payments are estimated to be $330.

That’s a massive difference on the same loan amount and the perfect example of why it pays to choose the right option.

(Please note: these monthly payment figures are simplified calculations taken from this calculator to demonstrate the impact of different interest rates and payback periods.)

3. Lower borrowing power

It’s not uncommon for it to cost $100,000 or more to complete a homeowner’s entire renovation wish list, and this usually means there’s a need to borrow money to make this a reality.

But using an unsecured loan is going to massively lower your borrowing power, perhaps even making it impossible to borrow the amount you need to tackle every project on your list.

You see, even though you might find unsecured loans that appear to let you borrow up to $100,000, the reality is that most borrowers won’t be able to borrow anywhere close to this with lending decisions based on your income, credit score and history and other debts.

In fact, these higher loan amounts are usually only available to people who have the highest credit scores, a perfect credit history and a higher income. They’re certainly not available to everyone who applies and the qualification criteria for these loans can get complicated.

What happens to those who have credit scores and an income just above the minimum requirement? They’re able to borrow a much lower amount than the maximum that’s on offer.

And while some people may settle for only undertaking a few of these and waiting to finish their home, that doesn’t need to be the case when alternatives exist that will make it possible to borrow what you need.

If you need to borrow big to tackle all of your wish list in one go, that’s probably not going to happen with an unsecured loan that limits your borrowing power. You’ll need to opt for a secured loan to make this happen.

4. Interest isn’t tax-deductible

The interest that you pay on a home equity loan that’s used to make substantial improvements to your home (one that adds value, prolongs its useful life or adapts a home for a new use) is tax deductible up to a loan of $750k for married couples or $375k for a single borrower.

In contrast, the interest on unsecured home improvement loans is not tax deductible.

And let’s not ignore the fact that these tax deductions can be sizable on larger loans, further demonstrating the importance of carefully considering your options.

When is an Unsecured Home Improvement Loan Right For Your Renovation?

It’s important to understand that there are some instances when an unsecured home improvement loan might be the best way to pay for your renovation.

But these probably aren’t what you think, and there’s a lot of myths surrounding the suitability of personal loans as a way to pay for home improvements.

You see, there’s a common misconception that unsecured home improvement loans (personal loans) are your only option if you’ve not built up sufficient tappable equity. But that’s not the case. RenoFi Loans, construction loans, FHA 203ks and Fannie Mae HomeStyle loans let you borrow based on your home’s after renovation value (but some of these options also have drawbacks that you’ll need to carefully consider - we’ll look at these below).

In reality, unsecured loans are usually only the best way to finance a renovation if:

• The total cost of the project is lower than $20,000.
• You need the funds fast (the whole process often takes just a few days).

And if these don’t apply to your project, there’s likely a better option that you should consider.

But maybe you don’t know what that option is?

Alternatives to Unsecured Home Improvement Loans

A number of alternatives to unsecured loans exist that can help you to afford to undertake your full renovation wish list now, rather than being forced into reducing the scope of your project or delaying it completely, like many homeowners do.

But they don’t all come with the same benefits and in reality, depending on your personal circumstances, some of these won’t be any better suited.

RenoFi Loans

When you remodel your home, its value will typically increase. We estimate that this is by an average of $75k for every $100k that’s spent.

And RenoFi Loans, a new type of home renovation loan that combines the best bits of a construction loan with a home equity loan, allowing you to borrow the most money at the lowest possible cost.

RenoFi Loans let you borrow against your homes after renovation value, tapping into the equity that will be available after the project has been completed now to pay for the work, all without having to refinance your first mortgage. This also means that they’re perfect for newer homeowners who haven’t yet built up enough equity to consider other options and who may have wrongly assumed an unsecured personal loan was their only option.

If you need to borrow more than $20,000 for your renovation, this type of loan could be the best option.

Here’s what you need to know about RenoFi Loans:

• Loan amounts from $20k to $500k
• Same low fixed rates as traditional home equity loans
• Term up to 20 years
• Ability to borrow up to 90% of the after renovation value
• Full loan amount available at closing

And when you consider that those who are often looking at unsecured loans as a way to finance their renovation are doing so because they either haven’t built up equity, don’t want to refinance or need the funds upfront, it’s easy to see why these are a solid option.

If you’re looking for the best alternative to an unsecured loan to pay for a renovation, there’s a good chance that it’s a RenoFi Loan.

Construction Loans

Like RenoFi Loans, construction loans let you borrow based on your home’s after renovation value, and they were once the only option that allowed this, but now, the reality is that most homeowners shouldn’t be using them to pay for a renovation.

Quite simply, construction loans:

• Add delays, hassle and complexity to the financing process.
• You will have to refinance your existing mortgage.
• You’ll face higher closing costs than most of the alternatives.
• Complicated draw processes mean you won’t get the money straight away.

In fact, some contractors completely refuse to work with construction loans and others hate them because of the extra work that they impose on a project.

So while they might allow you to borrow the money you need, the complexities cause stress that you can avoid with alternatives.

FHA 203k or Fannie Mae HomeStyle Loans

FHA 203k loans and Fannie Mae HomeStyle loans are government-backed renovation loans that will also let you borrow based on your home’s after renovation value, but like construction loans, they come with a complicated process involving inspections and draws. This often means they’re a poor choice for financing a renovation.

That said, these loans typically have lower credit score requirements than other options meaning they might be the right choice for some homeowners who would otherwise struggle to be approved for other types of financing.

Remember though that you’ll need to refinance with both of these options which could mean you end up on a higher rate.

See our guide on FHA 203k vs HomeStyle loans to see how they stack up against each other and learn more about the complicated process that these loans force you to follow.

Home Equity Loans & Lines of Credit

A home equity loan or line of credit (HELOC) has traditionally been one of the most common ways to pay for a renovation, and for those who have built up sufficient equity to finance their whole project in this way then it is still an option (although by no means the only one).

But just stop and look at how long it takes to build up $100k in tappable equity in your home:

It takes 10 years, basing the above example on a $400k home and a 15% down payment.

And when we consider that it’s not uncommon at all for a full remodel to cost more than this amount, it’s easy to see the problem for homeowners who have only recently bought a property but wish to carry out work to turn their house into their forever home.

Quite simply, using a home equity loan or home equity line of credit isn’t an option for people in this situation, but neither is waiting 10 years or more to renovate your home, as far as we’re concerned, especially when other options let you borrow based on the property’s after renovation value. Cash-Out Refinance

We’ve previously shared that refinancing is one of the dumbest things that homeowners do when paying for home improvements, and unless you’re doing so onto a lower rate, it’s probably not going to be the best way to pay for your renovation and will result in money being thrown away unnecessarily.

That said, for those who can lock in a much better rate, it could be a great option (and the RenoFi Cash-out Refi is coming soon). Choosing the Right Way to Pay for Your Renovation

Unless you’re only looking to borrow a small amount or need the results super quickly for whatever reason, then an unsecured loan probably isn’t going to be your best option.

But don’t forget that it pays to do your research and take the time to understand what the best option is to pay for your home improvements, being sure to compare the different alternatives that are available to you.

After all, making the wrong choice can mean higher monthly payments and lower borrowing power.

Why not speak with a RenoFi advisor today to talk over your options and let us help you to finance your renovation the right way.