Smart ways to use your equity for home improvement

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If you’re a homeowner who has paid down a significant portion of your mortgage, you may be sitting on a mountain of tappable equity. If your house is worth more than you owe on it, you may be able to use that equity to make home improvements.

Before tapping into your home equity, make sure to consider the pros and cons that come with taking out a loan for home improvement. Read on to lean more about your options and how you can make the most out of your home equity loan or HELOC.

Benefits of using your home equity for home improvement

As home values increase, more homeowners will have the capital to bankroll their home projects with equity loans. Home equity can be a smart way to finance a remodel, but only if you do it right.

Interest rates are low — home equity loan rates are currently about 5.23 percent APR and HELOC rates are about 4.88 percent APR. And interest you pay on home equity loans and home equity lines of credit, or HELOCs, is tax deductible if the money is used to remodel, repair or otherwise improve the value of the home that secures the loan.

Both loan products carry low interest rates because they are designed to allow homeowners to use the equity in their homes to maintain and improve property values. Since home value is the collateral on which equity loans are based, higher home values benefit homeowners and lenders.

Investing in your home is a smart idea, whether you’re looking to sell or just create a more comfortable space for yourself and your family. If you’re tossing around the idea of selling your house, renovations may help your home sell quicker and for more money. New paint, new carpeting and updated kitchens and bathrooms generally help increase the value of your home, making renovations a good return on investment.

Home equity loans for home improvement

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 upfront, making the loan a good option for large-scale improvement projects.

Cons

  • If your 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 home equity loans serve as a second mortgage, they come with closing costs and fees.

Home equity loans are given based on the same equity value that a HELOC would use. However, they are structured more like a traditional mortgage, with a repayment period and 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. The amount you can borrow is similar to that in a HELOC because most lenders will not lend you more than 80 percent to 85 percent of the equity you have in the home.

Home equity loans have a number of advantages. First, because the repayment schedule begins right away with the principal included, you know the amount of your monthly loan repayment and whether you can afford it. You can often get these loans at a fixed rate rather than a variable rate, which can save you interest in the long run.

If your home improvement project is contracted and it will be a few months before completion, you can move the money to an interest-bearing account while you’re waiting to spend it and earn back some interest. Be sure not to spend it on something else while you wait.

The biggest risk with a home equity loan is that you risk losing your home if you can’t pay it back, although this is the case with any type of loan that uses your home equity as collateral.

Home equity line of credit, or HELOC, for home improvement

Pros

  • Qualifying for a HELOC is simple as long as you have at least 20 percent equity in your home.
  • A HELOC is a line of credit (much like a credit card) rather than a loan, so you can use as much or as little 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, because you can borrow multiple times from your HELOC.
  • 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.
  • It can take a bit longer to get approved for a HELOC than a home equity loan.

A home equity line of credit, or HELOC, can be a useful option for home renovations because you’re extended a fixed line of credit and you can use as much or as little as you want, says Trevor Lane, CEO of Marshall, Everett & Associates, a mortgage finance company in Los Angeles.

All HELOCs have a draw period and a repayment period. The draw period is the amount of time you have to use the line of credit you were approved for. Once that period expires, you can no longer withdraw funds and you must start repaying the full loan.

Most HELOCs are adjustable-rate loans, although more lenders are offering fixed-rate options. With adjustable-rate HELOCs, the loan may have a fixed rate during the draw period, then the rate adjusts once the draw period expires. Other lines of credit adjust right away with the prime rate. In a rising-rate environment, loans will get more expensive.

For many home projects, the total cost is often not known until the renovation is complete. With a HELOC, you can withdraw only the amount you need. Consequently, you pay interest only on that amount. For example, if you’re approved for a $100,000 HELOC but use only $70,000, you owe interest on the $70,000.

Another advantage of a HELOC is that the monthly payments usually start out smaller than those of a cash-out refinance or personal loan. The reason for this is that borrowers are required to repay only the interest during the draw period.

For homeowners who want to make major renovations without having to make large monthly payments right away, HELOCs are a good choice.

The disadvantage of using a HELOC to fund projects is that it’s easy to get in over your head. You can borrow from your HELOC multiple times, which means you can make payments on what you borrow, pay down your debt and then borrow more money, creating a cycle of borrowing that may be difficult to keep up with.

Another downside is that many lenders charge a fee to keep HELOC accounts open, so you may owe payments on your line of credit whether or not you use it.

Lastly, if the housing market crashes, you may wind up owing more than your home is worth.

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Getting the most from your home equity loan or HELOC

Maximizing your home equity loan

Since home equity loans are disbursed in a lump sum, they can be useful for bigger projects. If you are planning a relatively large home improvement project, like a complete kitchen remodel or the addition of another section onto your home, a home equity loan may be a better solution for you than a HELOC.

However, it is imperative that you have a financial plan in place and are able to pay off the loan. Since home equity loans require you to use your home as collateral, you could risk losing your home if the loan is not paid off by the end of the repayment period.

  • Make your payments on time: It is important to consistently make your monthly payments. Since you use your home as collateral, you could run the risk of losing your home if you don’t make your payments on time.
  • Stick to your budget: Before you apply for a home equity loan, it’s wise to create a budget or a financial plan for how you will use the money. Since it’s distributed in a lump sum, it could be easy to quickly spend the cash on things other than home improvement.
  • Use it for larger projects: Due to the distribution of the funds, this loan may be best used for larger-scale home improvement projects. Remodeling kitchens and bathrooms or making major additions to your home are a few examples of how you can best maximize your home equity loan.

Maximizing your HELOC

HELOCs can be a great option for smaller home improvement projects, since they’re disbursed over a longer period of time. Unlike a home equity loan, a HELOC is a revolving line of credit, like a credit card. This means you can take out how much you want, when you want. While this is convenient, you still have to pay off the loan by the end of the repayment period or risk losing your home.

If you’re planning smaller-scale renovations or renovations that will continue for a number of years, this may be a good option for you. Plus, interest may be tax deductible if you use your loan for home improvement projects only.

  • Make your payments on time: As with a home equity loan, it is crucial to make your payments on time. While you’re only required to make payments on interest during your HELOC’s draw period, it may make sense to make payments on the principal as well; that way, you’ll lower your monthly payments during the repayment period.
  • Be aware of the fees: HELOCs can come with some fees that could have the potential to cut into the value of the loan. Annual maintenance fees and closing costs are two common fees with a HELOC.
  • Use it for smaller projects: HELOCs may be most effective when used for smaller-scale, long-term projects, since you have some flexibility over how much money you actually borrow during the draw period.

High-impact home improvements

People who use HELOCs to pay for home renovations might want to consider the return on their investment. For example, if you sink too much into a master bathroom, you might not be able to recoup the cost, says Christopher Gibson with Brokers Guild Cherry Creek in Denver.

A few ways to leverage your home equity for home improvements include:

  • Replacing old garage doors.
  • Investing in new lighting.
  • Replacing carpet throughout the house.
  • Applying a new coat of paint.
  • Adding an extra bedroom.
  • Renovating your kitchen.

Alternative home improvement loans

Personal loans

Another option for securing money for a remodel is a personal loan. Because personal loans are unsecured debt, interest rates have a broad range from about 6 percent to 30 percent or more, depending on your credit history, income and other factors.

However, personal loans can be a useful short-term solution to remodeling when you don’t have much equity but the improvements you are planning will increase the value of your home significantly. Though rates for personal loans are higher than those of equity loans, a personal loan is a great way to get money right away.

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.

Be careful, though, because interest rates can and will go up if you are late or miss a payment, and they can reach astronomical levels, so be sure to make payments on time and know what interest rate you’ll be paying if you can’t keep up.

The 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 are already expensive enough, and even a small difference in the interest rate can save you thousands of dollars over the years.

Featured image by Zivica Kerkez of Shutterstock.

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