Pros and cons of home improvement loans

Home improvement loans are a type of personal loan that allows you to use your funds to finance all or part of a home improvement project. From small renovations to full room renovations, a home improvement loan can help you fund your next project.

However, like all loans, home improvement loans do have some downsides. For example, if you don’t have stellar credit, it’s likely that you’ll be offered high interest rates, fees and prepayment penalties that will cut into the total value.

Before jumping into your next renovation or project, consider the potential drawbacks and advantages of a home improvement loan and how it could impact your finances down the road.

Home improvement loan benefits

Home improvement loans are an important tool for homeowners who need to make essential or cosmetic changes to their space. Because they come with fixed interest rates and let you borrow a large lump sum at once, they are a useful way to make payments more manageable.

Helps build credit

On-time payments will always be a great way to build up your credit score and can make future borrowing 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 is a major player in your credit score.

Finance a large project

There are lenders that offer up to $100,000 in personal loan funds. However, this isn’t a common maximum amount and not everyone will be able to qualify for such a large loan. But if you have a big project and the income to afford large monthly payments, opting for an unsecured home improvement loan won’t have you running the risk of losing your home if you default, like with a secured home equity loan.

Add value to your home

A home improvement loan can help you increase the value of your home by tackling a larger project than you could otherwise save for. What’s more, 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 that you’ll be on the hook for a predetermined payment amount every month. Installment loans can be the better financing solution for smaller, short-term projects, while longer, more expensive renovations may be better funded with a HELOC.

Home improvement loan drawbacks

Home improvement loans aren’t for everyone. Factors such as fees, high rates and hard credit pulls can describe the overall value of the loan and cause financial stress down the road.

Potentially high fees

Not every lender charges the same fees. There may be an origination fee on your loan that either deducts from the total amount you receive or increases the amount you borrow. Some lenders may also charge late fees and prepayment penalties. While both of these can technically be avoided, a prepayment penalty makes it much more difficult to save money if you’re able to make payments ahead of schedule.

The interest rate and fees make up your annual percentage rate (APR). If you have poor or fair credit, you’ll likely be given a high APR that can range up to 36%.

Some loans are secured

Most personal loans are unsecured, which means they don’t require collateral. However, some may be secured either by your home’s equity or by another asset, such as a savings or investment account. If you’re unable to pay your loan for a set amount of time and enter into default, the lender could seize your collateral to satisfy the delinquent balance. Even if a secured loan comes with lower rates, the risk potential is much higher and that’s a key factor to consider before signing on the dotted line.

Negative impact on credit

Applying for a home improvement loan will result in a small hit to your credit when the lender does a hard pull and if you miss any payments, it’s likely that you’ll see that negatively impact your score as well. Keep in mind that even if you make every payment on time, your credit could still be negatively impacted if the loan skews your credit utilization ratio or substantially increases your debt-to-income ratio.

When to get a home improvement loan

A home improvement loan — as opposed to a home equity loan or HELOC — is a good choice if you have a midsize project. You will need to have good to excellent credit to get the best rates, but even borrowers with fair credit may be able to take advantage of longer repayment terms to minimize monthly costs for necessary improvements.

Alternatives to a home improvement loan

Using your home’s equity, a credit card or your savings will be the most accessible alternative to a home improvement loan.

  • Home equity loans. A home equity loan allows you to tap the equity you have in your property. These tend to have lower rates than home improvement loans because they are secured. And just like a personal loan, they have fixed monthly payments and long repayment terms.

  • HELOC. A home equity line of credit (HELOC) also uses your equity as collateral. But it functions more like a credit card — you draw from your line of credit when you need to make a purchase. When that money is repaid, you will be able to draw from it again.

  • Credit card. Credit cards are the best for smaller projects, including weekend DIY. Even if you have a low credit limit, you may be able to purchase materials or pay for labor, then pay it off. But because minimum payments can cause interest to pile up, be sure you can afford to pay all or most of the amount by the end of the month.

  • Savings. The option that costs you the least will be to build up your savings. This is the best alternative to a home improvement loan because you won’t pay any interest — in fact, you may be able to earn interest if you have your money in a high-yield savings or CD account.

Home improvement loans should be used carefully

Home improvement loans are an important tool for many people who may not be able to build up their savings. But even if you can score low rates, they may still be risky if you struggle to keep up with payments or borrow too much.

Carefully consider the potential impact that taking on more debt will have on your financial health. Even before comparing lenders and looking into the details, conduct a financial audit to make sure your credit utilization ratio and debt-to-income ratio can handle more debt.