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How Do Home Improvement Loans Work?

Written by Allison Martin

Allison Martin is a personal finance enthusiast and a passionate entrepreneur. With over a decade of experience, Allison has made a name for herself as a syndicated financial writer. Her articles are published in leading publications, like, Bankrate, The Wall Street Journal, MSN Money, and Investopedia. When she’s not busy creating content, Allison travels nationwide, sharing her knowledge and expertise in financial literacy and entrepreneurship through interactive workshops and programs. She also works as a Certified Financial Education Instructor (CFEI) dedicated to helping people from all walks of life achieve financial freedom and success.

Updated January 25, 2024​

3 min. read​

how do home improvement loans work

Are you considering a costly home renovation or addition? If you don’t have the funds on hand to cover the costs and would prefer not to pull equity out of your home, a home improvement loan could work.

Before you apply for a home improvement loan, though, get an understanding of how they work. You also want to consider the qualification criteria to determine if they’re a good fit or if you should explore other options. 

Read on to learn more about home improvement loans and an alternative solution to cover your remodeling costs.

What Is a Home Improvement Loan?

A home improvement loan isn’t a particular type of debt product. Instead, it’s the term used for any kind of loan that’s used to pay for renovations and additions. Most fall into two categories: unsecured personal loans and home renovation loans. The latter includes construction loans, Fannie Mae Homestyle Renovation Loans and FHA 203k Renovation Loans.

How Does a Home Improvement Loan Work?

It depends on the type of home improvement loan you select. Here’s an overview of how each works: 

  • Unsecured Personal Loans: The application process for these loans is simple, but the loan amounts are generally lower, and you’ll pay higher interest rates. There are also origination fees, and the loan terms are shorter, which means your monthly payments could be steep. 
  • Construction Loans: These loans cater to individuals who want to build a new home but are sometimes used for home renovations. However, they should only be used as a last resort since the process is complex, and lenders generally require draw schedules and approvals. Most lenders allow you to borrow up to 80 percent of your expected property value minus the outstanding mortgage balance.
  • Fannie Mae Homestyle Renovation Loans: Backed by the federal government, Fannie Mae Homestyle Renovation Loans is a type of construction loan that allows you to borrow up to 95 percent of your home’s after-renovation value. You’ll generally have up to 30 years to repay the loan. Furthermore, private mortgage insurance (PMI) is tacked onto the loan if you borrow more than 80 percent of your home’s after-renovation value. 
  • FHA 203k Renovation Loans: The federal government also backs these loans and lets you borrow up to 96.5 percent of a property’s future value. The major drawback is the FHA mortgage insurance that you’ll pay when you get the loan and for the entire repayment period. 

What Credit Score is Needed for a Home Improvement Loan?

It’s at the discretion of the lender to set the minimum credit score for home improvement loans. Here’s a general idea of what score you’ll need for the different types of home improvement loans: 

  • Unsecured Personal Loans: varies by lender, but the most competitive interest rates are reserved for borrowers with good or excellent credit
  • Construction Loans: 700 or above
  • Fannie Mae Homestyle Renovation Loans: 620 or higher with a 5% down payment
  • FHA 203k Renovation Loans: 580 with a 3.5 percent down payment, but many lenders require a minimum credit score of 620 or higher. You’ll also need a 10 percent down payment if your credit score is between 500 and 579. 

Quick note: the maximum allowable debt-to-income (DTI) also varies by lender and loan product. Aim for a DTI of 43 percent or lower to give yourself the best shot at getting approved. You can calculate your DTI by dividing your total debt obligations for the month and dividing this figure by your gross monthly income. To illustrate, if the sum of your credit card, auto loan, mortgage, and other debt payments is $3,500 and your earnings before taxes and other deductions are $7,000, your DTI is 50 percent.

What Else Do You Need to Qualify for a Home Improvement Loan?

When you’re ready to apply for a home improvement loan, prepare to provide the most recent pay stubs or W-2 forms along with bank statements for the two most recent months. 

You’ll also need a substantial amount of equity in your home, proof of homeowners insurance and the most recent mortgage statement if you’re considering a home equity loan or a home equity line of credit (HELOC).

(Quick note: If you’re applying for a personal loan, the lender may only request proof of income and analyze your debts to determine if you qualify). 

Can You Use Your Home Improvement Loan for Anything?

Home improvement loans are marketed as a smart way to fund renovations and additions. If you choose to fund your remodel through an unsecured personal loan, most lenders won’t restrict the way funds are used. However, if you opt for a renovation loan, most lenders will allow you to use the funds towards renovating, remodeling or repairing your home.

Where to Get a Home Improvement Loan

Home improvement loans are offered by brick-and-mortar banks, online lenders, and credit unions. But before you decide on a loan product, shop around to determine what options are available to you.

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