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How to Felt Wool
Before beginning any upcycle project with wool sweaters, you need to felt the wool. This is done so that you can cut and sew the wool without it unraveling. It involves washing 100% wool sweaters in hot water, so that the wool shrinks and creates a tightly woven fabric. For step-by-step felting instructions, check out this excellent article by Patricia Oliver.
When looking for sweaters to upcycle for a craft project, you should choose 100% wool sweaters and be sure that the tag does not say “superwash." Wool mixes will not felt as nicely. Any sweater labeled “superwash" has been chemically treated to avoid felting.
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There are loads of scarf projects online for felted wool. A quick Google search will produce loads of results. The easiest way to make a scarf from felted wool is by cutting out rectangles and stitching them together end to end. You don't need to finish edges because they won't unravel. Knitty has a free project here for creating an embellished scarf from felted wool.
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Lee Meredith of CraftStylish wrote a tutorial for sewing a blanket from felted wool sweaters. This describes how to make a blanket with squares of wool for an almost quilt-like look. As you can see from those two projects, there is a lot of room for creativity with blankets. You can always add other fabrics to these projects, too, like cotton backing for a softer feel on the back of your blanket.
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Mittens are an easy project to recycle old wool sweaters. Trace a mitten shape around your hand on a piece of paper. Then draw a line 1/4" around the first outline for seam allowance. Cut out the shape, pin it on your felted sweater. Carefully cut the wool around the paper. Make four pieces. Take two pieces and pin them, right sides together. Sew 1/4" seam starting from one side of the wrist to the other. Turn them right-side out. You can sew wrist cuffs on using the wrists from a sweater if you wish. Here are some lovely examples from FeltSewGood's Flickr stream. PlanetGreen has some good instructions for mittens, too.
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Finishing with Felted Seams
After you felt some wool sweaters, you're almost ready to start a project. Before you start sewing, read this post by Betz White about felted seams. Instead of attaching blocks of felt together by sewing a normal seam, Betz illustrates how to created a Felted Seam by needle felting roving over stitches. In contrasting colors, it adds lovely detail. In matching colors, it would create a finished look with a little extra texture.