How to finance home renovations

1. Home equity loans

If you have equity in your home to draw against, banks can loan you money by using that equity as collateral. Simply put, if you’ve paid off a large portion of your mortgage, banks can lend you a lump sum close to that amount, depending on the current value of your home. Remember that your ability to take out any loan is dependent on your credit and your ability to pay off that loan.

This is a helpful solution for expensive home improvements, but all loans have their drawbacks.

A home equity loan will reduce the available equity in your home, so you’ll be less able to take out these kinds of loans in the future. You’ll also have to make monthly payments on a home equity loan in addition to the mortgage you’re already paying. Banks use the amount you want to borrow and the length of your loan term to calculate your monthly rate.

For example, a home renovation loan of $21,000 at 6% interest would cost around $230 a month if you paid it off in 10 years. If you paid it off in 20 years, it would run you $150 a month.

2. Home equity line of credit (HELOC)

A home equity line of credit, sometimes called a HELOC, also uses the equity of your home as collateral. However, this loan is not distributed as a lump sum; instead, you can access this money as you need it via checks.

This line of credit is available over a specified amount of time, usually 10 to 20 years, and then the line of credit ends.

HELOCs can be useful for those who don’t yet know how much they’ll need to spend on their home improvement project. Note that the interest rate is usually variable, meaning you could be forced to make higher payments in the future.

3. Cash-out refinancing

Another route for those who have equity in their home is a cash-out refinance. As a homeowner, you may be eligible for cash-out refinancing if your home value is worth more than what you owe on your house. This could be because you’ve built enough equity in your home through years of payments or because the market fluctuations have caused the value of your home to increase since you purchased it.

When you refinance your mortgage, you take out a new loan to pay off your existing mortgage. If you take out a refinance mortgage that is worth more than what you currently owe on your home, you can use the excess to fund your home renovation project.

Unlike a home equity loan, a cash-out refinance creates a new mortgage loan — a home equity loan creates a secondary loan in addition to your original mortgage loan. Cash-out refinances tend to have better interest rates than home equity loans or any other secondary loan.

If you’re planning a large renovation and don’t have equity in your home, a personal loan can be a good option to finance your remodel. On average, personal loans are issued for between $1,000 and $50,000, though larger personal loans are available. These limits give you quite a lot to work with for your renovation budget.

Depending on your credit score and the state you live in, personal loan interest rates average around 10%, making them a little pricier than home equity loans but more affordable than credit cards. With a personal loan, you typically have between one and five years to repay the balance. Longer repayment terms reduce your monthly payments, but you pay more in interest over the life of the loan.

5. Credit cards

Around a third of homeowners use credit cards to pay for their home improvement projects. If you don’t have the savings to pay for renovations, they can be a big help. And when you pay them off quickly, it could actually boost your credit score. Combined with the rewards some cards offer, this could translate to airline miles or cash back rewards.

But they’re not perfect. While credit cards offer rewards for spending, the high interest rates could end up costing you more than you want to pay. For example, if you spend $3,000 on a credit card with a 17% interest rate, your minimum monthly payment might be somewhere around $72.50. Paying that every month, it would take you 63 months and an extra $1,500 to pay off the whole debt.

This is just one example, but it goes to show how easily credit card debt can get out of control. Talk with an accountant before taking out a large chunk of credit, as it could end up harming your finances.

Bottom line

Financing home improvements can be tricky. Taking some time to build up savings and paying cash is always a top choice, but it’s not always feasible. Without a large savings account, you may need to take out a home renovation loan. Talk your options out with a local bank or financial advisor before making a decision — these choices can affect your personal finances for years to come.