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.
Chances are there are a few changes you’d like to make to your house. After all, spending on home remodeling and improvements has been on the rise for several years. By the first quarter of 2020, home improvement spending is expected to hit $400 billion annually, according to the Joint Center for Housing Studies at Harvard University.
“Typically, a lot of remodeling does happen around the point of the sale. But we’re seeing that existing homeowners are doing more projects and they’re spending more money on renovations,” says Abbe Will, a research associate at the center.
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 5.85% APR and HELOC rates are about 6.3% APR. And interest you pay on home equity loans and home equity lines of credit, or HELOCs, is tax-deductible — but only 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, 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
- 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.
- 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.
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 can 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% to 85% 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.
Home equity line of credit, or HELOC, for home improvement
- Qualifying for a HELOC is simple as long as you have at least 20% equity in your home.
- A HELOC is 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 personal loans or credit cards.
- 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.
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.
The average interest rate for HELOCs fluctuates, and is currently at 6.23%. “So, the HELOC can be a good tool to make updates to someone’s property,” says Lane of Marshall, Everett & Associates.
Another advantage of a HELOC is that the monthly payments are usually smaller than 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.
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
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 very 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 equity loans, a personal loan is a great way to get money right away. Once the value of the home has increased, you have equity and can refinance.
If you use this strategy to increase your home value, it’s smart to know where interest rates are. For example, if today’s rates are lower than what you are paying on your current mortgage, it might be smart to refinance all your home debt at once and combine it with the balance due on the personal loan.
If you have discipline and excellent credit, you may qualify for a credit card offering a 0% interest rate for a certain term. If you qualify for a credit card with a 0% 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 payment on time and know what interest rate you’ll be paying at if you can’t keep up.
The bottom line
Shop around at multiple lenders to find the best deal on a home equity loan. Even a small difference in the interest rate can save you thousands of dollars over the years.