American homeowners are sitting on a mountain of tappable equity. For some homeowners, this creates opportunities to make home improvements.
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 $347 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.
Using HELOCS and home equity loans to remodel
As home values increase, more homeowners 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. 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.
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.
Most HELOCs are tied to the prime rate, which is currently at 5.50 percent. “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.
Home equity loans
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 includes 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 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.
Remodeling with personal loans
Another option for getting money to 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.
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.
Replacing an old garage door and tracks, for example, is a high-return investment. Homeowners can expect to recoup about 98 percent of the cost, according to Remodeling magazine’s 2019 Cost vs. Value Report.
Lighting also goes a long way, says Gibson. For homeowners who plan to sell their home, investing in lighting, particularly if your home is dark, makes an impact on buyers.
“Don’t draw attention to the fact that your home doesn’t get a lot of natural light. Put in lights and get rid of dark corners wherever you can. Buyers are drawn to bright spaces,” Gibson says.
New carpet and fresh paint are not only inexpensive upgrades, they also give the home a move-in ready feel.
“The smell of new paint and new carpet is powerful. It really adds to the impression that this house has been well-maintained,” Gibson says.
Adding an extra bedroom and updating kitchens are also great ways to increase the value of your home, depending on the home and the neighborhood, while expensive walk-in closets probably won’t translate into more value at resale, says Lane.
One final word: 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.