Home Improvement Loans: What You Need to Know

Home Improvement Loans What You Need to Know-title

So, you’ve grown sick of your home? Maybe some parts have fallen into disrepair, or maybe you just want to modernize your home’s look. That means you’ll need to invest some money into home improvements!

If you’ve got the money lying around to hire contractors, purchase new floors, knock down walls, get inspections, and do all of the other things that go into home improvements, then good for you! However, most people don’t have that kind of scratch just sitting around.

You might think that this would be the end of the line, but it’s not. There are actually a number of different loan programs that homeowners can avail themselves of in order to secure the funds they need make home improvements!

Each of these programs has its own pros and cons, and one or another may be right for you and your particular circumstance. So, to help you out, we’ll be reviewing the primary options that available to you, from home equity loans to an FHA program that’s great for purchasing a fixer-upper!

Once you know what they’re all about, you can decide for yourself if it’s time to get that loan and to make those improvements you’ve been dreaming of. So, let’s get started!

Table of Contents

  1. Home Equity Loans
  2. Home Equity Lines of Credit (HELOCs)
  3. Federal Housing Loans (FHA Loans)
  4. The FHA 203k
  5. Title 1 Property Improvement Loans
  6. The Energy Efficient Mortgage Program
  7. What If I Have Bad Credit?

1. Home Equity Loans

When it comes to getting a loan for home improvements, this is the most common loan that homeowners will reach for. Often, you’ll hear homeowners refer to them loans as “second mortgages”. They’re incredibly simple, and they have a number of attractive benefits.

The basic premise is this: You will go to a bank to seek a loan, wherein your home will be used as collateral. Provided the bank approves the home equity loan, you’ll receive a check for the loan’s full amount and will then be able to use those funds in any manner you see fit. Generally speaking, you won’t have much to worry about in terms of qualifying for the loan itself – unless your credit is truly atrocious.

The value of the loan will depend upon two things. First, the bank will take into account your home’s appraised value, as this is the collateral for the loan. Second, they’ll consider how much you’ve paid off on your mortgage (if you have one).

Typically, a home equity loan will have a repayment term of somewhere between 10 and 15 years. Also, you’ll find that home equity loans typically have low interest rates, as there’s relatively little risk for the lender – you’ve put your house on the line, after all!

Home equity loans offer one really exceptional benefit that’s sure to make your ears perk up: the interest you pay on these loans is tax deductible. There are a few limitations to this, though, that you should be aware of.

For one, only interest on a loan that’s taken out for a first or second home is tax deductible. (What the IRS considers to be your “first” and “second” home will depend upon how much time you spend in each – something to keep in mind.) Second,  only the first million dollars in interest payments are tax deductible if a home equity loan is used for home improvement expenses.

All of this sounds great, right? Well, let’s tap the breaks a little bit.

Remember that, with a home equity loan, you’re putting your house up as collateral. This means that if you default on your payments, the lender can and will take your home. That’s a compromising position to be in!

For this reason, you really want to make sure that you’ve made a solid financial plan for dealing with your home improvements. Have a budget, and be sure that the improvements you’re making are increasing the value of your property. If you fail to do this, you could find that things turn upside-down, and that’s not a good outcome!

2. Home Equity Lines of Credit (HELOCs)

A home equity line of credit, known more commonly as a HELOC, functions similarly to a home equity loan. As before, your home is put up as collateral. However, this time you receive a line of credit rather than a lump-sum loan.

To determine the line of credit, the lender will consider the appraised value of your home as well as how much of your mortgage has been paid of (if you have one). At a maximum, you’ll be able to borrow up to 85% of your home’s appraised value.

This line of credit is issued to you in the form of a credit card, which you can use to borrow money on an as-needed basis. If you’re only going to be making minor, incremental improvements to your home, this might make the HELOC a great option.

As with a home equity loan, the interest that you pay on the money you borrow is tax deductible. However, you’ll still be subject to the same stipulations with respect to this deduction that we outlined above.

However, the subject of interest payments and HELOCs deserves closer consideration. Typically, when your line of credit is issued, the lender will extend a particularly appealing interest rate. However, this rate is only intended to be introductory, and it can balloon quickly over the course of a few months. In fact, over the time in which you have access to the line of credit, the interest rate will be completely adjustable. In comparison, a regular home equity loan will have a fixed interest rate.

There is another problem with HELOCs that a potential borrower should be aware of: the balloon payment. Although these are not as common as they once were, they’re still out there. Essentially, a balloon payment is a large fee that’s due at the end of a loan’s term. Lenders will use these “balloon payments” to defray the “cost” of extending a particularly attractive interest rate at the front of the loan. As a general rule, you should avoid a HELOC with a balloon payment; they’ve been the ruin of many a homeowner.

Provided these last two points aren’t deal breakers, a HELOC could work well for you. It is important to keep this in mind, though. Unlike with a home equity loan, you’ll have a credit card that you can use at any time, however you see fit.

Be honest with yourself. Are you capable of having a credit card in your wallet with an extremely high limit? Can you resist the urge to use some of that money to take that vacation or to buy that Ultra HD television you’ve had your eye on? If you can, then you should be fine. But, if you’ve had trouble with credit cards in the past, or worry about your self control, we’d recommend avoiding HELOCs.

3. Federal Housing Loans (FHA Loans)

The Federal Housing Authority (FHA) has been around since the Great Depression, and in that time it’s had only one goal: making homeownership affordable for Americans. To do this, the FHA backs loans that lenders extend to homeowners, thereby lowering the level of risk that those lenders take on. In turn, this allows lenders to extend loans to a wider section of the population.

For this reason, FHA loans may be particularly attractive to homeowners who have average to good credit. As a matter of fact, the minimum credit score required to qualify for a full loan through the FHA is 580. Depending upon your credit, that could be welcome sight for sore eyes!

Below that threshold, there possibility of securing an FHA loan still exists. If your credit score is between 500 and 580, then you can qualify for a loan that has a 90% loan-to-value ratio. For those would-be borrowers whose credit scores happen to fall below the 500 mark, an FHA loan will be unavailable.

Now, before you get too excited, it’s important to understand something about FHA loans. Because the lending standards are less strict than they would be with other loans – like a home equity loan, for example – those who receive an FHA loan are required to carry mortgage insurance. The premiums for the mortgage insurance are paid in two parts.

First, a homeowner will be required to pay an upfront premium, known as an MIP, that’s equal to 1.75% of the total loan. So, if you were to a secure a $100,000 loan, then a $1,750 mortgage insurance premium payment would be due upfront. After that, the premiums are paid in monthly installments over the duration of the loan. These payments will be included as part of your mortgage payment, so there’s no need to worry about two separate bills!

Aside from the mortgage insurance associated with FHA loans, there’s another important feature of these loans to consider. A borrower’s total monthly expenses, which include everything from mortgage payments to homeowners insurance, cannot exceed 31% of the borrower’s (or household’s) monthly income. In some cases, this threshold can be extended to 47% of the borrower’s (or household’s) monthly income, but the lender will need to prove that this is warranted to the FHA.

The above issues regarding loan qualification and mortgage insurance withstanding, FHA loans can be an excellent way to secure the funds you need to tackle your home renovations. If you’re unable to secure a home equity loan or HELOC due to less than stellar credit, then by all means speak with a lender about what options exist for you with respect to an FHA loan!

4. The FHA 203k

Now, you may not be making improvements to a home you already have; perhaps you’re looking into making improvements to a home that you’ve yet to purchase. This is what the FHA 203k loan is all about!

With these loans, would-be homebuyers can purchase a home that’s in need of massive renovations, securing the finances they need – through the loan itself – to make all of those renovations. Depending upon the property you’re looking at and the renovations that are required, this may be a way to get the home of your dreams for a song!

The process for securing an FHA 203k loan works much the same as securing a regular FHA loan. However, instead of the loan only covering the cost of the home, there will be additional funds to cover the projected cost of renovations. There are two kinds of FHA 203k loan that you can get: regular and streamlined. A regular FHA 203k loan is for home’s the require structural renovations, and a streamlined FHA 203k loan is for home’s that require simple repairs and cosmetic renovations.

For this reason, it’s important to develop a solid budget when hammering out the terms of the loan. There won’t be a need to worry if you go over budget, though, as there’s typically a 20% reserve set up with the loan that can cover anything that exceeds the budget projection.

There’s another benefit to FHA 203k loans that’s built right in. Given that the home you’re purchasing will need massive renovations, you’ll typically be provided with sixth months of mortgage payments so that you’re able to live elsewhere while the renovations are completed. That really makes the whole process so much easier!

Now, this is important to remember: These loans can only be secured when purchasing a new property. Unfortunately, they’re not available for a home that you already live in. Too bad…

5. Title 1 Property Improvement Loans

A Title 1 loan is an incredibly simple way to secure the funds you need for home improvements. The loan program is administered by the Department of Housing and Urban Development (HUD), and functions much the same way as the FHA’s loan program. HUD backs lenders that extend loans to homeowners looking to make repairs, renovations or alterations to their properties.

Now, a Title 1 loan may or may not work for the home improvement project you have in mind. For single-family homes, the maximum loan amount is $25,000, which can be paid back at a fixed rate for a maximum period of 20 years. For multi-family homes, $12,000 can be secured per unit to a maximum of $50,000, and the loan can be paid back at a fixed rate over a maximum of 20 years.

Unless your credit is absolutely abysmal, you should be able to easily secure one of these loans. However, keep the loan size in mind!

Home improvement projects are often quite expensive, and things regularly go over budget. If you think your total budget might be close to the maximum loan value and that you might go over, it might be wiser to pursue one of the other loan options above. Nothing would be worse than exhausting the loan and being stuck with a half-finished renovation and no money on hand to complete them.

6. The Energy Efficient Mortgage (EEM) Program

With energy prices continuing to skyrocket, the government has instituted various programs to help Americans become more energy efficient. One of these programs happens to pertain to homes. It could help you to get new appliances that help you save money on your monthly bills!

It’s called the Energy Efficient Mortgage (EEM) Program, and it’s administered by the Department of Housing and Urban Development (HUD). More or less, the program works as a kind of tack-on to another loan, like a FHA 203k or home equity loan. In addition to the base loan, additional funds are provided that are to be used for the purchase of energy efficient appliances and upgrades – everything from better insulation and heating systems to refrigerators and ovens.

Best of all, you do not need to qualify for additional financing when seeking an EEM loan. If you can demonstrate what you intend to do with the additional funds, the extra financing will be added to what you and the lender have already agreed to. Considering how much an energy efficient home can save you on your monthly utility bills, this can be a real win-win.

7. What If I Have Bad Credit?

In order to avail yourself of the home improvement loans that we’ve outlined above, you’re going to need at least good credit. Especially after the recent recession – which was sparked, in large part, by home loans – lenders are reluctant to work with borrowers who seem “risky”.

Unfortunately, the only way that lenders have to judge an individual borrower’s level of risk is the borrower’s credit score. If your credit score runs from the low 500s to the low 600s, you’re pretty much on the bubble when it comes to securing many of the loans we’ve discussed. However, you’re not without options!

There’s something called a B/C paper loan, which functions in almost the exact same manner as a traditional home equity loan. However, you need to be warned. The interest rates associated with these loans are quite exorbitant, and the higher monthly payments could put you and your home at risk of foreclosure if you’re not able to keep up.

If the home improvements you need to make are an absolute necessity – following an environmental disaster, for example – and there are no other options available, then by all means look into B/C paper loans. However, if you’re merely looking to make cosmetic changes, then avoid B/C paper loans entirely. Instead, spend some time rehabilitating your credit so that you can qualify for one of the other, more beneficial loans we’ve already discussed.