Home Equity Vs. Home Improvement Loans

••• Jupiterimages/Creatas/Getty Images

You can borrow money using the value of your home as a guarantee, and you can use that money for any purpose. You can also borrow money specifically for the purpose of renovating or repairing your home without any guarantee. Any loan that is backed by the value of your home is called a home equity loan, whereas a home improvement loan is a secured or unsecured loan for fixing up your home.

Obtaining an Equity Loan

When you apply for an equity loan, the lender bases the amount you can borrow on the equity value of your home, which is the difference between its appraised value and your outstanding mortgage balance. For instance, if the lender appraises your home at $300,000 and you have a $150,000 mortgage balance, the equity value of your home is $150,000. If your credit meets the lender's requirements, you will usually qualify for a loan of at least 75 percent of the equity, or $112,500. When you take out a home equity loan, it is essentially a second mortgage, and you pledge your home as collateral for the loan.

Getting an Improvement Loan

Some lenders may call their unsecured or secured loans home improvement loans for marketing reasons. These loans can be used for any purpose, whereas a true home improvement loan is based on the appraised value of the renovations you plan to carry out. When you apply for an actual home improvement loan, the lender requires you to obtain bids from the contractor you plan to hire for your project. The lender will then appraise the bid to make sure it reflects a reasonable price and proper quality of work. After checking the bid and your credit, the lender will offer you a loan to cover the price of the work. The lender will inspect the work periodically before releasing payment to the contractor. Some lenders, particularly publicly funded ones, will loan you money for do-it-yourself home renovation projects.

Repayment Term Comparison

You begin making payments on your home equity loan as soon as you are approved, and you may pay closing costs that include an initial interest payment. The usual repayment period is 15 years, and you must pay back any balance that remains if you sell your house before you fully repay your equity loan. A home improvement loan is a short-term loan, and you begin to repay it when your renovation project is finished.

Comparing Major Advantages

The major advantage of a home equity loan is that you can use the funds for any purpose, as it is based solely on the equity value of your home and your credit rating. A home improvement loan may not require you to pledge your home as collateral, and it is ideal for remodeling your home as the lender ensures the quality and timeliness of the work you need done by tying contractor payments to its inspections. The contractor won't be able to try to pressure you for early payments or hold the job hostage, because you won't have the money unless the lender gives its okay.

Comparison of Major Disadvantages

If you take out a home equity loan and the value of your home decreases, you will end up with negative equity in your home, meaning that the amount you owe on your mortgage and your home equity loan are equal to more than your home's market value. You also run the risk of losing your home if you are unable to make regular payments. A home improvement loan is inflexible when compared to a home equity loan, as you can use it only for the exact renovations that your lender approved. A home equity loan is best when you need funds to cover general expenses or for major home renovations. A home improvement loan is best suited to taking care of a specific project in your home, such as replacing your roof or furnace.