My Perfect Mortgage
Choosing Between HELOC and Home Improvement Loan for Home Equity Renovation
6 minute read
May 1, 2024

Dreaming of a kitchen remodel or a luxurious bathroom upgrade? 

Tapping into your home equity can be a smart way to finance these renovations, but with two popular options—the Home Equity Line of Credit (HELOC) and the Home Improvement Loan—choosing the right one can feel overwhelming. 

This article will break down the key differences between HELOCs and Home Improvement Loans, helping you decide which best suits your project and financial goals.

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Understanding Home Equity Loan Basics

A home equity loan is a type of loan where you borrow against the equity in your home. If the value of your home is greater than what you owe on your mortgage, you have equity in your home that can be used as collateral.

This type of secured loan typically has a fixed interest rate and a repayment term over the life of the loan. It works like a second mortgage, with the loan amount based on the difference between your home value and the amount you owe on your current mortgage.

This type of loan can also be referred to as a home equity loan for home improvement or a HEL.

Factors to Consider Before Using a Home Equity Loan

Before tapping into your home’s equity for a renovation project, consider the following:

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  • Interest rate: Home equity loans typically offer competitive interest rates, but be sure to compare rates from multiple lenders.
  • Closing costs: Factor in origination fees, appraisal costs, title fees, and any other closing costs associated with the loan.
  • Monthly payment: Consider how the additional monthly payment will impact your budget. Use a home equity loan calculator to estimate your monthly payment and ensure it's comfortable for you.

Your financial situation:

  • Home equity: You'll need sufficient equity in your home to qualify for a home equity loan. Lenders typically require a loan-to-value (LTV) ratio of 80% or less, meaning your home's value minus any existing mortgage balance should be at least 20% of the loan amount.
  • Debt-to-income ratio (DTI): Lenders will consider your DTI ratio, which compares your total monthly debt payments to your gross monthly income. A lower DTI ratio improves your chances of qualifying for a loan and may lead to a better interest rate.
  • Credit score: A good credit score (typically above 670) can qualify you for a lower interest rate on your home equity loan.

Your renovation project:

  • Project scope: Home equity loans are lump-sum loans, meaning you receive the entire amount upfront. This is ideal for projects with a fixed cost.
  • Timeline: Consider how long your renovation project will take. Home equity loans have a fixed repayment term, so you'll need to factor in the entire project cost even if the work is spread out over time.

The Benefits of a HELOC for Home Improvements

Financing a home renovation can be easier with a Home Equity Line of Credit (HELOC). Unlike a fixed-sum home equity loan, a HELOC offers a credit line you can tap into as needed, similar to a credit card.  This flexibility is ideal for projects with unknown costs or those spread out over time.

Key benefits of using a HELOC for renovations include:

  • Competitive Interest Rates: HELOCs typically offer lower interest rates than other loan options like personal loans, making them a cost-effective way to borrow.
  • Interest Paid Only on What You Use: You only pay interest on the amount of credit you utilize, reducing your upfront financial burden compared to a fixed-sum loan.
  • Leveraging Home Equity: HELOCs use your home's equity as collateral, potentially leading to a lower interest rate than unsecured loans.

Remember, responsible HELOC use involves considering your home's equity and creditworthiness when determining your borrowing limit.

Interest Rates and Loan Terms: Key Considerations for Home Equity Borrowers

Financing your renovation with a home equity loan or HELOC involves key considerations: interest rates and loan terms.

  • Interest Rates: HELOCs typically offer variable rates, which can fluctuate over time. Fixed-rate home equity loans provide more predictability in your monthly payments. Choose a fixed rate if you prefer stability, or a variable rate if you expect interest rates to stay low.
  • Loan Terms: Shorter loan terms mean higher monthly payments but lower overall interest costs. Conversely, longer terms offer lower monthly payments but you'll pay more interest over time. Choose a term that fits your budget and project timeline.

By comparing interest rates and loan terms, you can choose the option that best suits your financial goals and project needs.

Qualifying for a Home Equity Loan or HELOC: Credit Score and Collateral Requirements

  • Solid Credit Score: Lenders typically require a good credit history to qualify for a HELOC. This demonstrates your ability to manage debt responsibly.
  • Home Equity: HELOCs are based on your home's equity, which is the difference between your home's value and what you still owe on your mortgage.  The higher your equity percentage (typically at least 15-20%), the more you can potentially borrow.
  • Debt-to-Income Ratio (DTI): Lenders will consider your DTI ratio, which compares your total monthly debt payments to your gross monthly income. A lower DTI indicates a stronger ability to handle additional debt.
  • Stable Employment and Income: Demonstrating a steady income source assures lenders of your ability to repay the borrowed funds.

Personal Loans vs Home Equity Financing

Financing a home renovation involves weighing the pros and cons of different loan options. Here's a breakdown of personal loans compared to home equity financing:

Personal Loans

  • Convenience: Personal loans offer a fast and straightforward application process. Funds can be readily available without using your home as collateral.
  • Unsecured Loans: Unlike HELOCs, personal loans don't require putting your home at risk. This can be ideal if you have lower equity or prefer not to use your home as security.
  • Fixed Interest Rates: Enjoy the predictability of fixed monthly payments with a personal loan's fixed interest rate.
  • Potential Drawbacks: Personal loans typically offer lower loan amounts compared to home equity options. Interest rates might also be higher than those on a HELOC, depending on your creditworthiness.

Home Equity Financing (HELOC):

  • Access Larger Loan Amounts: HELOCs leverage your home's equity, allowing you to potentially borrow more than with a personal loan.
  • Potentially Lower Interest Rates: HELOCs often have lower interest rates than personal loans, especially for borrowers with good credit and high equity.
  • Secured Loan: Since your home serves as collateral, qualification might be easier for those with lower credit scores. However, this means risking foreclosure if you can't repay the loan.
  • Variable Interest Rates: HELOCs typically come with variable interest rates, which can fluctuate over time, potentially impacting your monthly payments.

The Takeaway

Consider a personal loan if speed, convenience, and unsecured borrowing are priorities. However, be prepared for potentially lower loan amounts and higher interest rates.

HELOCs are a good option if you need a larger loan, potentially qualify for a lower interest rate and are comfortable using your home as collateral. Just be mindful of the variable interest rate that can affect your monthly payments.

Ultimately, the best choice depends on your financial situation, project scope, and risk tolerance.

Our advise is based on experience in the mortgage industry and we are dedicated to helping you achieve your goal of owning a home. We may receive compensation from partner banks when you view mortgage rates listed on our website.