Oct 28, 2019 | Debt

What’s the best way to pay for a home renovation?

The situation

With two kids and a dog, and my wife working from home, our cozy three-bedroom house is just too small. We want to stay in the neighborhood but can’t afford to buy a bigger place. But we can maybe swing adding a bedroom over the garage and finishing the basement—which would be a game changer. The equity we have in our house gives us options, but I’m looking for the best way to pay for a home renovation of this size. Help?

—Seth, Worcester, Mass.

With nearly 80% of homes in the U.S. at least 20 years old, more people are feeling the need to renovate in some way. If you’ve come up with a realistic budget to get it done and have determined how much you’ll need to borrow, it’s smart to take the time to examine your loan options.

Home improvement loan

Don’t let the name fool you. These loans, offered by most banks and credit unions, are not tied to the equity you have in your home, nor exclusively to “home improvement.” They are also known as personal loans, meaning you don’t have to put up collateral, but you are liable if you can’t make your payments. Because there is no collateral for banks to take if you can’t pay them back, personal loans are riskier for financial institutions, so they generally charge more interest than if you put your house on the line. Rates can vary wildly—from 6% to 36%, according to NerdWallet—depending on your credit score, income, outstanding debt, and other factors. If you can secure a loan on the lower end of this spectrum, this may be a good option for you.

Pros: Home improvement loans have a fixed interest rate, set repayment timeline, and monthly payments that won’t change over the life of the loan (usually a relatively short two to seven years). Also, your home is not immediately in the balance if you can’t pay it back. Finally, these loans are highly flexible—there aren’t restrictions on how you can spend the money.

Cons: You need good credit to qualify for the best rates. Unlike with some of the alternatives below, you cannot get a tax break with these loans.

Home equity loan (HEL)

If you have equity in your home (that is, you owe less than its market value, as determined by a bank-appointed appraiser), a loan like a HEL that uses that equity as collateral has advantages. The bank considers them safe loans to make, and allows you to borrow for longer terms.

Pros: Because banks view HELs as less risky than personal loans, they charge borrowers low, fixed interest rates for them (currently around 5.75%), typically repaid over 5 to 15 years. Another plus? The interest you pay is tax-deductible, with certain limits. (For more info, sink your teeth into IRS Publication 936.)

Cons: Your home is at risk if you can’t make your payments. Also, you’ll have to fill out a lot of the same paperwork as you did for your mortgage.

Home equity line of credit (HELOC)

This loan also uses your house as collateral, but it functions more like a credit card. Here’s how it works: You, the homeowner, get a line of credit from the bank. (More often than not, it comes with a plastic card you can use.) During what’s known as the “draw” period, you can spend up to the limit of the credit line. The draw period is usually 10 years, which makes a HELOC convenient if you are doing renovations over a longer timeline. During this period, you’re only required to pay interest; when the draw period is over, you must start paying back the principal as well.

Pros: The rates are more favorable than those of credit cards. A $30,000 HELOC currently has an average rate of around 6.3%.

Cons: As with a credit card, a HELOC’s interest rate is variable and can result in monthly payments that fluctuate depending on a number of economic factors, including rates set by the Federal Reserve. And that’s doubly concerning because your home is on the line. Like a HEL, it involves a lot of paperwork.

Federal FHA loan

If you don’t have enough equity built up in your home to obtain a traditional home equity loan or a HELOC (a typical minimum for eligibility is about 20%), consider a loan through the Federal Housing Administration’s Title I Property Improvement Loan Program (aka FHA Title I). This program aims to help low- to moderate-income borrowers finance home improvements that will “make your home more livable or useful.” This means there are restrictions on how you can use the money. New appliances or changes to make your home wheelchair-accessible, for example, are allowed. A pool or an outdoor fireplace is not. And FHA Title I loans are not ideal for large projects: The amount is capped at $7,500 (unsecured), and $25,000 (for loans backed by your home.)

Pros: As with HELs and HELOCs, the interest you pay on FHA Title I loans is tax-deductible. (Again, see IRS Publication 936 for details.) And if you moved in recently and haven’t yet built up much equity, you can still get one. What’s more, the government has no requirements for home equity, credit score, or income.

Cons: Aside from the loan caps and the restrictions on what you can use the money for, the costs can be higher than that of HELs or HELOCs. In part that’s because your bill includes an annual government-mandated mortgage insurance premium equal to 1% of the loan.

Credit card

I know what you’re thinking: “Beth, I can’t believe you’re suggesting this!” And I hear you. But using a low- or no-interest card (say, one with a special introductory rate) can be your best option, particularly for smaller renovation projects or for a chunk of a larger project. Even if it’s just a way to purchase the construction materials your contractor will use. You’ll want to cap the amount. It’s only smart if you can pay it off before the interest rate is scheduled to rise.

Pros: There are credit cards with introductory rates as low as 0% that last for 18 months, as of this writing. It’s hard to beat zero interest. Plus, your home isn’t on the line. A bonus: There’s no long paperwork-filled application process.

Cons: If you go over budget, or the job takes longer than you expected, you can get into dangerous territory and be at the mercy of rising credit card interest rates that cause your monthly payments to spike dramatically once the introductory period ends. Even though the Federal Reserve has been reducing its benchmark rate recently, you never know what the next year will bring. Note that many contractors aren’t set up to take credit cards, so check ahead of time.

One final tip: Hands off your retirement account

Some homeowners, desperate for a remodel, borrow from their 401(k). This is risky, but it can seem appealing. Especially if you’re worried about taking on new debt. After all, you’re borrowing from yourself, right?

Pros: When you borrow money from your own retirement plan, you are paying yourself back—plus interest. And the paperwork is relatively straightforward. Still, I’d skip it because the cons (below) are major.

Cons: You have to pay these loans back within a certain period or risk hefty tax penalties, especially if you leave your job or are laid off. (The IRS has the details here.) Another technical but not insignificant consideration for 401(k) loans: You pay a double-tax penalty. First, when you pay the interest on your 401(k) loan, you are using after-tax money. That money will be taxed a second time when you make withdrawals in retirement. Again, that’s double taxation! Last but not least, any pre-retirement futzing with your 401(k) is likely to hurt your earnings, leaving you less for your golden years. In the end, upgrading your house shouldn’t risk downgrading your financial future.