The amount of equity you have in your home is the portion of your home you’ve already paid off. If your house is worth significantly more than what you still owe on your mortgage, you might be able to use that equity to pay for home improvements or renovations. Before tapping your home equity for remodeling, however, consider the pros and cons.

Benefits of using home equity for home improvement

Lower interest rates

Both home equity loans and lines of credit (HELOCs) carry relatively lower interest rates because your home is the collateral for the loan. Those with good credit will have access to the most competitive rates.

Potential tax deduction

The interest you pay on home equity loans and HELOCs might be tax-deductible, but only if the funds were used to substantially improve the home that secures the loan. Currently, joint filers can deduct the interest on up to $750,000 worth of qualified loans, while single filers or married filers filing separate returns can deduct interest on up to $375,000. These figures represent a reduction from prior limits of $1 million for joint filers and $500,000 for individual tax returns. You must itemize deductions in order to take advantage of this benefit.

Possible return on investment

Investing in your home is generally a smart idea, whether you’re looking to sell or create a more comfortable space for you and your family. If you’re considering selling your house, renovations might help it sell more quickly and for more money.

Drawbacks of using home equity for home improvement

Your home is on the line

The biggest drawback to consider before signing on the dotted line for a home equity loan is the risk of losing your home should your financial situation change unexpectedly. If you fall behind on payments, your home could be foreclosed.

The loan might be more than you need

Using home equity for home renovations works best when you’re making significant improvements or have multiple renovation projects. Often lenders have minimum borrowing requirements, which means you’ll need to be prepared to take out a substantial amount of money, more than you might feasibly need to use.

“A home equity loan can be a great option for borrowers if they’re looking to cover a large expense,” says Nicole Straub, formerly the general manager of Discover’s home loans unit. “Loan amounts tend to be higher than for unsecured loan products like personal loans.”

If you have smaller projects or renovations in mind, it might not make sense to take a loan that not only involves high minimum borrowing amounts but also includes closing costs and requires putting your home on the line as collateral. A personal loan or even a credit card could be a better choice for such circumstances.

Additional costs

Because a home equity loan is a second mortgage, you’ll pay closing costs and fees which can range from 2 percent to 5 percent of the loan. These costs can include an origination fee and appraisal fee. Factor these fees into the total cost of the loan when deciding if it makes financial sense for your situation and needs.

Home equity loans vs. HELOCs for home renovation

Two of the most popular options for borrowing money for home renovations are home equity loans and HELOCs. The two share many similarities: They both use the equity in your home, they both use your home as collateral and they both typically allow you to borrow up to 80 percent or 85 percent of your home’s value, minus your outstanding mortgage balance. However, the two have several differences, and they each have their pros and cons.

Home equity loans for home improvement

Home equity loans are structured more like a traditional mortgage, with a set schedule of payments that include both principal and interest. They are essentially second mortgages and typically come in terms of 10, 15, 20 or 30 years.

Pros

  • Payments are structured and begin right away, which makes it easier to budget.
  • Home equity loans usually have a fixed rate, so the amount you pay will likely stay at or close to the same amount each month.
  • If you aren’t planning to start remodeling immediately, you can move the money to an interest-bearing account and earn money on your money.
  • All money is disbursed up front, making the loan a good option for large-scale improvement projects.

Cons

  • If your home remodeling project is going to be a lengthy process, you may be tempted to spend the money on other things instead.
  • A home equity loan is a secured loan against your house, so if you stop making payments, the bank can take possession of your home.
  • If home values take a dive, you may owe more on your loan than the home is worth.
  • Since a home equity loan is a second mortgage, it comes with closing costs and fees.

Home equity line of credit (HELOC) for home improvement

All HELOCs have a draw period and a repayment period. During the draw period, you can borrow money from the line of credit and may only be responsible for interest-only payments. Once that period expires, you can no longer withdraw funds, and you must start repaying both principal and interest.

Pros

  • You can use as much or as little money as you need and only pay back what you use.
  • Interest rates are usually lower than those of personal loans or credit cards.
  • During the draw period, you may be given the option to make interest-only payments.

Cons

  • HELOCs are variable-rate loans, which means the interest you pay will fluctuate and affect your monthly payments.
  • It can be easy to take on more debt than you can afford since you can borrow from your HELOC multiple times and don’t have to start paying principal right away.
  • Many lenders charge an annual fee to keep the HELOC open, whether you use it or not.
  • If home values fall, you may owe more than the home is worth.

Alternatives to home equity loans for home improvement

If you’d rather not use your home equity for home improvement projects, you have other options:

  • Personal loans: Because personal loans are unsecured debt, interest rates range up to 36 percent, depending on your credit history, income and other factors. However, a personal loan can be a useful short-term solution for remodeling when you don’t have much equity but the improvements you are planning will significantly increase the value of your home. Though rates for personal loans are higher than those of home equity loans, you don’t risk losing your home if you default.
  • Credit cards: If you have discipline and excellent credit, you may qualify for a credit card offering a 0 percent interest rate for a certain term. If you qualify for a credit card with a 0 percent interest promotion, it can mean financing a home improvement with no interest, provided you can pay the credit card off before the promotional term ends. Interest rates can and will go up if you are late or miss a payment, and they can reach astronomical levels.
  • Cash-out refinance: With a cash-out refinance, you refinance your mortgage for more than what you currently owe, replace your current mortgage with a new one and take the difference in cash. Keep in mind that cash-out amounts may be limited, and this option is only smart if you can get a lower interest rate on your mortgage. Before committing, get quotes from a few lenders offering refinancing.

Bottom line

If you’re looking to renovate your home, tapping your home equity may be a good way to find funding. Shop around at multiple lenders to find the best deal on a home equity loan. Home improvement projects can be expensive enough, and even a small difference in the interest rate can save you thousands of dollars over the years.