How do Home Improvement Loans Work?

Renovations and repairs on your home can be expensive, and paying cash for them may not be an option, so you may consider using a home improvement loan to finance any major projects. While the term “home improvement loan” is commonly used to describe a personal installment loan that is earmarked for home improvement, there are other forms of funding that fall into this category.

What is an installment loan for home improvements?

We’ll start with the simplest type of loan – a personal loan. A personal loan is an installment loan that provides you with a lump sum of money. The lender typically approves the borrower based on their credit history and credit score (among other things). Interest rates are typically fixed, and repayment is done by making regular monthly installments that are the same amount for a specified number of months.

Personal loans typically don’t come with stipulations on how the money can be used. The borrower can state that it’s for home improvements, but the lender doesn’t require them to spend the money on anything specific. This makes this type of funding appealing because the borrower can ask for an amount beyond the cost of the improvements and perhaps use the balance for other needs.

Home Equity Loans and HELOCs

A home equity loan allows you to borrow against the equity (value) you’ve earned in your home and receive the funds in one lump sum. Home equity loans typically come with fixed interest rates and repayment terms, making them a predictable financing option.

While borrowing against your home equity could reduce the amount of equity you have in your home, some of your home improvements might help increase the property’s value, potentially restoring or even growing equity over time.

Home Equity Line of Credit (HELOC)

A HELOC works similarly to a home equity loan, but functions more like a credit card. Instead of receiving a lump sum, homeowners are approved for a line of credit and can withdraw funds as needed. The draw period for a HELOC can be as short as 3 years or as long as 10, while the repayment period can be up to 20 years – but these terms will ultimately vary by lender. A HELOC can be ideal for ongoing or long-term renovation projects, where costs may fluctuate over time. However, since HELOCs often have variable (changing) interest rates, the monthly payments can change depending on market conditions.

Both home equity loans and HELOCs can provide lower interest rates compared to unsecured personal loans, but they also come with risks. Because the home is used as collateral, failure to repay could result in foreclosure. So, it’s important to carefully assess all of your options before taking this route.

Cash-Out Refinancing (Refi)

Cash-out refinancing allows you to tap into your home’s equity by replacing your existing mortgage with a new, larger loan and receiving the difference in cash. This option can provide funds for home improvements, debt consolidation, or other major expenses. However, because this loan is secured by the home, failure to repay could lead to foreclosure.

The amount a you can borrow depends on your home’s current value and the lender’s loan-to-value (LTV) requirement.

While cash-out refinancing can be beneficial, it comes with new terms, closing costs, appraisal fees, and the risk of higher monthly payments—especially if interest rates have risen since you took the original mortgage out. You should carefully compare the costs and potential benefits before proceeding, as alternative options like home equity loans or HELOCs may be more favorable depending on your financial goals and market conditions.

The Bottom Line: Home Equity is an Investable Asset

Personal installment loans for home improvements don’t require equity, but you’re acquiring new debt when you agree to take one on. That makes them an expense. Using the equity in your home to increase its value is an investment. Choosing which of these is best for you may be dictated by the nature and price of the project.

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