How Do Home Improvement Loans Work?

Typically, a "home improvement loan" refers to an unsecured personal loan used to pay for home renovations. But personal loans aren't your only financing option for remodels and repairs.

The best way to pay for a home remodel depends on factors like your home equity, credit and goals. Here are six types of home improvement loans and how each works.

When you get a personal loan for home improvement projects, you don’t secure it with your home. In fact, lenders typically don’t consider any information about your home with a personal loan. Instead, a lender decides how much to lend to you and at what rate based on your financial credentials, like your credit score and income. 

Personal loans are an option if you don’t have a lot of home equity or you don’t want to use your home as collateral, says Charlie Rocco, certified financial planner at Moneco Advisors in Connecticut.If you fail to repay a personal loan or don’t pay it on time, your credit score will take the hit.

“Even though you haven’t pledged your home, the downside is that you’ve essentially pledged yourself and your earning power,” he says.

Getting a personal loan tends to be quicker than the home equity options, says Dana Menard, a Minnesota-based certified financial planner. And you repay more quickly. Personal loan terms are usually capped at five or seven years, while home equity options can stretch over decades.

The best rates on personal loans are reserved for borrowers with good or excellent credit (a score of 690 or higher), but some online lenders offer home improvement loans for bad credit. Once you have a cost estimate for the project, calculate your monthly payments and check them against your budget to see what you can afford.

» CALCULATOR: See your monthly home improvement loan payments

With a cash-out refinance, you get a larger loan with a new interest rate and repayment term and “cash out” the difference to pay for your project.

Because cash-out refinancing involves revising your mortgage, it works best when rates are low, says Charles Sachs, CFP at Kaufman Rossin, a financial services firm in Miami.

That gives you a chance to recoup the costs of refinancing, typically 2% to 6% of the mortgage. Check your closing costs against your project’s budget to be sure the new mortgage will be worth it. Closing on a $350,000 mortgage could cost as much as $21,000, which may be more than you plan to spend remodeling.

» COMPARE: Best cash-out refinance lenders

You’ll recoup more of those costs over the life of the loan if you stay in the home long-term, Sachs says. He generally recommends staying for seven or more years.

“If you’re planning on living in this house for, let’s say, the next 10, 20 or 30 years, then it’s not a financial payoff," he says. "It’s the enjoyment of the property and being able to lock in very low rates."

The money for a HELOC comes from your equity, which is the value of your home minus the amount you owe on it. It’s a second mortgage, so you’re using your house as collateral.

HELOCs have a draw period, usually 10 years, when you can use some or all of the funds you’re approved to borrow. During that time you usually make interest-only payments, Rocco says. You’ll repay interest and principal during the later repayment period.

Since you don’t have to pay the principal during the draw period, Rocco says, a HELOC makes sense if you plan to sell in the foreseeable future. The principal you haven’t paid will be subtracted from your sale, but you won’t have to repay the funds out-of-pocket.

Getting a HELOC gives you flexibility when you don’t know exactly how much the renovation will cost. They’re especially useful for projects you’re doing in stages, like a basement remodel, Menard says.

HELOCs have variable rates, so if the thought of a rising rate bothers you, it may not be the right option, Menard says.

» COMPARE: Best HELOC lenders

Home equity loans, the fixed-rate cousin of HELOCs, are a good choice if you already know how much you’re going to spend. Unlike HELOCs, you get the funds from this second mortgage in a lump sum, and you immediately start repaying both interest and principal.

One benefit of the home equity loan is that since each payment goes toward the loan’s principal from the start, you’re building your equity back up immediately, Rocco says.

Home equity loans have fixed rates, so when rates are low you have the chance to lock in low monthly payments.

If you’re getting a home equity loan, knowing the cost of your project is key, Sachs says. He recommends getting a quote at the same time the lender underwrites your loan.

“Maybe I’m considering building a pool, so I’m getting a pool estimate and at the same time I’m working with my lender to understand feasibility of borrowing,” he says.

» COMPARE: Best home equity loan lenders

High APRs on credit cards make them suitable for smaller updates like a splash of paint and some small furniture additions, Menard says. They can also help cover a surprise repair or extra expense during a larger project, Rocco says.

Credit cards with 0% APR promotional periods are usually ideal for short-term projects that you can pay off before the promotion ends.

If you don’t pay off the card during the promotion — typically 15 to 21 months — you could face steep interest rates.

» MORE: Best credit cards for home improvement projects

The Department of Housing and Urban Development offers Title I Loans, which can help you finance a home renovation project at little or no expense, Menard says.

These loans are government-issued, and the requirements typically vary by state and municipality, he says. They’re for renovations that improve your home’s “basic livability or utility,” according to HUD.

If your plans include energy-conscious updates, you may be eligible for a government-issued energy-efficient mortgage.

The North Carolina Clean Energy Technology Center maintains a database of state and local incentives for energy-efficient updates.

» MORE: First-time home buyer loans and programs

Tax incentives for eco-friendly updates

Starting in 2023, some projects that reduce your home’s energy use or increase its efficiency qualify for certain tax credits. 

Energy-efficient doors, windows, heat pumps, air conditioners and home energy audits qualify for a 30% tax credit, up to $1,200 per year. Tax credits reduce your tax liability, so a $150 tax credit can reduce your taxes owed by $150. Solar panels also qualify for a 30% tax credit with no cap on the amount you can claim.