Advantages and disadvantages of home improvement loans
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Advantages and disadvantages of home improvement loans

May 16, 2023
Verified by Irene Scott
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Home improvement loans are a type of personal loan that allows you to use funds to finance all or part of a remodeling project. Whether it is a small renovation or a complete room makeover, a home improvement loan can help you finance your next project.

However, like all loans, home improvement loans have drawbacks. For example, if you do not have excellent credit, you may be offered high interest rates, fees and prepayment penalties that will reduce the total value of the loan.

Before embarking on your next renovation project, consider the potential advantages and disadvantages of a renovation loan and the impact it could have on your long-term finances.

Advantages of a home improvement loan

Home improvement loans are an important tool for homeowners who need to make essential or cosmetic changes to their homes. Because they have fixed interest rates and allow you to borrow a large sum in one lump sum, they are a useful way to make payments more manageable.

They help build credit

Being on track with your payments is always a good way to improve your credit rating and make future loans less expensive. In addition, you can build your credit by expanding the types of credit accounts you have. If you only have a few installment loans, a home improvement loan can diversify your credit profile, which plays an important role in your credit score.

Financing a large project

Some lenders offer personal loans of up to $100,000. However, this maximum amount is not common and not everyone may qualify for such a large loan. However, if you have a major project and an income that allows you to pay high monthly installments, opting for an unsecured home improvement loan means you do not risk losing your home in case of default, as you would with a secured home improvement loan.

Increased home value

A home improvement loan can help you increase the value of your home by carrying out a larger project than you could have saved for. Also, if you plan to sell your home, you can recoup some of what you spent and make your home stand out more on the market.

Fixed payments

Home improvement loans are fixed-rate installment loans, which means you will have to pay a predetermined amount each month. Installment loans may be the best financing solution for small, short-term projects, while longer and more expensive renovations are best done through a HELOC.

Disadvantages of renovation loans

Renovation loans are not suitable for everyone. Factors such as fees, high rates, and difficulties in applying for credit can reduce the overall value of the loan and lead to long-term financial difficulties.

Potentially high fees

Not all lenders charge the same fees. Loans may include an application fee that is deducted from the total amount received or that increases the amount of the loan. Some lenders may also charge late fees and prepayment penalties. Although both types of penalties can technically be avoided, a prepayment penalty prevents you from saving money if you are able to make payments earlier than expected.

The interest rate and fees make up the Annual Percentage Rate of Charge (APR). If you have poor or bad credit, you will probably have a high APR, as high as 36 percent.

Some loans are secured

Most personal loans are unsecured, that is, they do not require collateral. However, some may be secured by the equity in your home or another asset, such as a savings or investment account. If you are unable to repay the loan for a specified period of time and you default, the lender may forfeit the collateral to pay off the balance. Although the rates on a secured loan are lower, the potential risk is much higher and this is a key factor to consider before signing on the dotted line.

Negative impact on credit

Applying for a home improvement loan will have a slight impact on your credit when the lending institution conducts a thorough search, and if you fail to pay, your score will likely be negatively affected as well. Keep in mind that even if you make all payments on time, your credit could be negatively affected if the loan changes your credit utilization ratio or significantly increases your debt ratio.

When to apply for a home improvement loan

Unlike a home equity loan or HELOC, a home improvement loan is a good choice if you have a medium-sized project. You must have good or excellent credit to get the best rates, but even people with average credit can benefit from a longer repayment period to reduce the monthly costs of needed improvements.

Alternatives to a home improvement loan

The most cost-effective alternatives to a home improvement loan are using equity, credit cards, or savings.

  • Equity loans. Equity loans allow you to use funds from the property. Rates for these loans are usually lower than for commercial loans because they are secured. Also, like personal loans, they have fixed monthly payments and long repayment periods.
  • HELOC. The home equity line of credit (HELOC) also uses the value of the property as collateral. But it works more like a credit card: you draw on the line of credit when you need to make a purchase. Once the money is repaid, you can use it again.
  • Credit card. Credit cards are ideal for small projects, including weekend DIY. Even if the credit limit is low, you can buy materials or pay for labor and then pay off the bill. However, since minimum payments can carry interest charges, make sure you can repay all or most of the amount at the end of the month.
  • Save money. The cheapest option is to accumulate savings. This is the best alternative to a home improvement loan because you pay no interest; in fact, you can even earn interest if you deposit the money in a high-yield savings account or a current deposit account.

Home improvement loans should be used with caution

Home improvement loans are an important tool for many people who do not have the opportunity to accumulate savings. However, even if you can get low rates, they can be risky if you struggle to make payments or if you borrow too much.

Think carefully about the potential impact of extra debt on your financial health. Before you even compare lenders and look at the details, do a financial check to make sure your credit utilization and debt ratio can handle additional debt.

Irene Scott
Written by
Irene Scott
I’ve worked for more than 5 years as a Credit Analyst and more than 4 years as an Internal Auditor for one of the leading global financial institutions. I have been exposed to the credit review process, various banking products, financial security topics, corporate governance, operational risk, and the internal control framework of a complex, multinational organization.