Credit Scores and Home Improvement Financing

Homeownership can be both a blessing and a curse. In honor of National Homeownership Month in June, we wanted to shine a light on how remodeling your home, freshening up a living space, replacing the bathroom tile, or renovating to improve your home’s value – and your quality of life – can be a worthwhile investment.

Depending on the scope, these projects can range from a few hundred dollars to several thousand. And  your credit scores can open a lot of doors. If you’re planning to finance home projects, the higher your scores, the lower your interest rates!

Here are some home improvement financing options to explore:

Home equity loans

A common way to finance remodeling is with a home equity loan, sometimes referred to as a second mortgage. Like your first (primary) mortgage, this is a loan taken out against the equity in your home. If you have been paying your mortgage for a few years and property values have risen, there is a good chance you have accumulated a fair amount of equity in your home. A home equity loan can be a convenient way to turn that equity into cash.

Be mindful that while second mortgages are popular products at most banks and lending institutions, they often involve higher interest rates than first mortgage loans. That is because the term “second mortgage” has another meaning. If you were to default, any funds available would be used to pay off your first mortgage (the one you used to originally buy the home) before any payments are made on the second. If there is not enough equity to settle both mortgages completely, the lender in the “second” position may not get everything owed on that mortgage.

For this reason, lenders view both second mortgages and home equity loans as carrying more risk. Therefore, it is generally recommended to use this type of loan only if the interest rate is affordable and you will be able to pay it back. Of course, this reasoning applies to all loans.

Home equity line of credit

A home equity line of credit works in much the same way as a credit card. A lender gives you a borrowing limit, but charges interest only on the amount you use. You also have access to the funds when you need them, which is a big plus if your project spans an extended period of time.

There are typically no closing costs associated with a home equity line of credit, and although interest rates are adjustable, most are tied to the prime rate. Repayment timelines typically vary between eight and 10 years. Banks, credit unions, brokerage houses and finance companies all market these loans aggressively, so you should have no problem finding potential lenders.

Government-backed home improvement financing options:

There are two government-backed loan products that are aimed at those planning to remodel: Fannie Mae’s HomeStyle® Renovation mortgage and the Federal Housing Administration’s 203(k) Rehab Mortgage Insurance.

  • Fannie Mae HomeStyle Renovation Mortgages. This program, administered by the government-sponsored mortgage company Fannie Mae, provides mortgages to homeowners and investors alike. Borrowers can use HomeStyle funds to pay for just about any remodeling-related expenses: inspections, engineering and architectural fees, permits and, of course, the renovations themselves.
  • Federal Housing Authority’s 203(k) Rehab Mortgage Insurance. The FHA’s 203(k) product enables home buyers and homeowners to finance (or refinance) the purchase of a house and any rehabilitation costs through a single mortgage. While some improvement loans have relatively high interest rates and short repayment terms, the 203(k) is an attractive option because it offers a long-term fixed-rate or adjustable-rate loan. The proposed renovations must cost more than $5,000, but the funds can be used to offset a relatively long list of expenses: construction, elimination of health and safety hazards, plumbing work, roof replacement and more.

Credit cards

Credit cards can be a tempting option when it is time to remodel, but proceed with caution. Unless you can avoid paying interest on the purchase – if you have a zero percent introductory rate, for instance – credit cards effectively add an interest charge (sometimes significant) to the renovation total.

The best credit card-financing scenario is to have a card that offers a cash-back reward and that you pay the entire balance before you incur interest. That brings you the benefits of cash back or points without adding interest to the cost of the remodel.

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