If you’re dreaming of a new kitchen, master suite or outdoor deck and you’re not sure how to finance it, there are several options you can consider. The key is figuring out the best option for your situation.
Your Home as Collateral
Since you’re planning a home improvement, it often makes sense to secure financing for such projects using the equity you have already built up in your home. There are three options for doing this, each of which works a bit differently—but for all of them, you typically need about 20 percent equity in your home. As Bankrate explains, “Equity is the difference between how much you owe and how much your home is worth.” For example, if your home is valued at $200,000 and the balance on your mortgage is $160,000, you have $40,000 or 20 percent in equity.
The first option is to take out a home equity line of credit or HELOC, which is a revolving line of credit that you can draw on (up to the limit that you are approved for) whenever you need funds. It’s important to understand that a HELOC is a secured loan, which means that your home is used as collateral.
This variable rate loan is typically tied to the lender’s prime rate, which means that your interest rate can fluctuate up or down.
A HELOC consists of two distinct phases. First is its draw period, when you can take funds as needed and you’re only required to pay down the interest. The draw period lasts anywhere from five to 15 years, depending on your lender. After the draw period ends, the loan converts to its repayment phase, when you make set payments for the remaining balance, typically between 10 to 20 years.
A HELOC works well for borrowers who:
- Have significant equity in their homes
- Are confident about repayment, considering that (as collateral) their homes can be subject to foreclosure
- Like the flexibility of drawing funds as needed over time for various purposes
Home Equity Loans
A home equity loan is similar to a HELOC in that your house is used as collateral, but it is structured differently. A home equity loan is a second mortgage on your home that is a one-time, fixed-rate loan tied to longer-term interest rates, typically with a five- to 10-year term.
Like a HELOC, a home equity loan works well for borrowers who have significant equity in their homes, high repayment confidence, and who are in these situations:
- Longer-term interest rates are lower than the short-term rates used for HELOCs
- They know exactly how much money they need up front for a project
The final financing option that uses home equity is a cash-out refinance. In this case, you refinance your entire mortgage with the total new loan amount, including a cash sum that you receive at closing. You have your choice of fixed or variable rate loans, as well as the length of your repayment term.
A cash-out refinance works best for borrowers with a lot of equity in their homes in these circumstances:
- The current mortgage rates available are lower than their existing mortgage rate
- They have excellent credit scores to qualify for the best rates
- Desire no restrictions on the use of the money being cashed out
Other Financing Options
Don’t worry if you don’t have much equity in your home — you can still finance your home improvement project using these other two lending vehicles. Both work best for those with good-to-excellent credit scores.
Instead of basing your loan on your on your home’s collateral, a personal loan is based on your credit score, income, and financial history. There are more personal loan options available today than ever before. Many, including a loan through Prosper, are fixed-rate and fixed-term, which means you’ll know exactly what your payment will be for the life of the loan (and exactly when it will be paid off).
Additional benefits of personal loans:
- Fixed loan payments help you budget your loan repayment into your monthly cash flow
- No need for a home appraisal
Finally, you can choose to pay for your home improvement with a credit card; just choose wisely. A credit card makes sense when:
- You’re eligible for a 0% introductory rate (preferably on a card also offering rewards).
- You’ll be able to pay off the project before the introductory rate period ends.
Take Your Time With Your Decision
Financing a large project is a big decision, so take your time to research and learn about your options so you make a decision that works best for your situation. You shouldn’t rush to select a contractor to complete your project, and the same goes for choosing how and from whom to get your project’s financing.