Deciding how to finance expensive home improvements often comes down to a choice between a home equity line of credit (HELOC) and a personal loan. According to HomeAdvisor, the average cost of a new deck is about $7K, while a complete kitchen renovation can cost $10K-$30K. Most homeowners require some type of loan to make these types of improvements. The most important factors in making this decision include the following:
- Loan amount
- Interest rate
- Tax deduction
Choosing between a HELOC and personal loan can be a challenge due to the number of factors involved. The first step is to understand the difference between the two types of loans.
A HELOC is a type of loan that uses your home as collateral, meaning the lender can repossess it if you default on the payments. Your ownership, or equity, in the home also determines the maximum amount you can expect to receive from a lender. Furthermore, you may not qualify for a HELOC at all if you don’t have sufficient equity in your home.
A HELOC is a revolving line of credit for an amount that the lender determines, meaning you can use it much like a conventional credit card. You can also borrow against a HELOC as you make payments. In some cases, the interest you pay can be deducted from your income when you file your tax return.1 Some lenders offer variations on the standard HELOC. For example, Figure’s HELOC provides the entire loan amount upfront, but you can continue drawing on the credit line as you repay what you borrow.2
A personal loan is unsecured, meaning it doesn’t require collateral. The lender can still sue you for non-payment, although it’s very unlikely that you would lose your home. You can therefore borrow as much as a lender is willing to risk, regardless of your equity. However, you will have to apply for a second loan if you need more money, because a personal loan has a fixed term and payment schedule. Furthermore, the interest on a personal loan isn’t tax-deductible.
The amount you need to borrow is usually the most important factor in determining whether you should finance your home improvement project with a HELOC or a personal loan. The amount you can borrow with a HELOC is limited by your equity. Assume for this example that your home is worth $250K, but you still owe $190K on it. Most HELOC lenders require a loan-to-value (LTV) ratio of 70-80%, meaning that the total value of your HELOC and mortgage can't be more than 70-80% of the value of your home. If your lender's maximum LTV ratio is 80%, the maximum value of your HELOC and mortgage in this example couldn’t exceed $200K ($250K x 0.8). Since you already owe $190K on the mortgage, the maximum amount of your HELOC couldn't exceed $10K ($200K - $190K).
In the example above, if your home improvement project will cost more than the $10K that you can expect to receive from a HELOC, you'll need to consider a personal loan or a combination of a HELOC and a personal loan. It’s possible that neither type of financing alone will provide enough money to cover your home improvements. The amount you can borrow with a personal loan depends primarily on your credit rating and income.
A HELOC provides greater flexibility than a personal loan because you pay interest only on what you actually spend. Furthermore, interest stops accruing on what you borrow as soon as you pay it back. In comparison, interest accrues at a constant rate with a personal loan. The fixed principal of a personal loan can be particularly disadvantageous for a major home improvement project, which often has unexpected costs. You may not be able to obtain a second personal loan if your project goes over budget.
With a HELOC, if a project goes over budget, you would be able to borrow more money, provided you have enough room on the credit line. This also is especially helpful when you have a seasonal requirement for credit, which commonly occurs during major home improvements. In addition, a HELOC typically remains open for several years, allowing you to pay for ongoing repairs.
You’ll also need to compare interest rates to determine the best way of financing home improvements. A rate decision depends on personal factors and general economic conditions, so it’s difficult to predict which form of financing will result in the lowest interest rate. Homeowners with only fair credit will probably get a lower interest rate with a HELOC, especially if they have high equity. However, the rate on a personal loan can be lower if you have sterling credit and a high income. Bankrate shows that the national average for the interest rate on a $30K HELOC was 6.3% in December 2019, whereas the starting interest rate for personal loans was 5.95%. Bear in mind that only the strongest loan applicants would be able to qualify for that personal-loan rate.
The possibility of a tax deduction is one of the primary reasons to choose a HELOC over a personal loan. You can generally deduct the interest you pay on a HELOC, provided you use the money to improve your home. Depending on the size of the loan and your tax bracket, this tax advantage could make a HELOC a better deal for you even if you qualify for a personal loan with a lower interest rate.
It pays to shop around when you need to borrow money for your home improvement project, whether you use a HELOC or a personal loan. A borrower with high equity but a low income and credit score is more likely to be better off with a HELOC, while a borrower with low equity and good credit may be better off with a personal loan.
You also need to take the tax deductibility of a HELOC into account when comparing interest rates of HELOCs and personal loans. Finally, a HELOC tends to be better for prolonged home improvement projects that have a higher probability of cost overruns.
2The Figure Home Equity Line is an open-end product where the full loan amount (minus the origination fee) will be 100% drawn at the time of origination. The initial amount funded at origination will be based on a fixed rate; however, this product contains an additional draw feature. As the borrower repays the balance on the line, the borrower may make additional draws during the draw period. If the borrower elects to make an additional draw, the interest rate for that draw will be set as of the date of the draw and will be based on an Index, which is the Prime Rate published in the Wall Street Journal for the calendar month preceding the date of the additional draw, plus a fixed margin. Accordingly, the fixed rate for any additional draw may be higher than the fixed rate for the initial draw. You must pledge your home as collateral, and you could lose your home if you fail to repay.