Home equity loans are popular among homeowners looking to fund renovations at a lower interest rate than other financing options.
The most common uses for home equity financing are home improvement projects and debt consolidation. Using a home equity loan to make home improvements comes with a few benefits that other uses don’t. When you use your loan for home improvements, you get the double benefit of tax-deductible interest while adding value to your property. This isn’t the case if you use those funds to consolidate debt or cover another big expense.
As with any financing decision, you want to have a clear picture of why you’re borrowing (the purpose) and how you will pay it back. Here’s how to best use a home equity loan to take on remodeling projects, as well as important pros and cons to consider.
How does a home equity loan work?
With a home equity loan, you borrow a set amount of money and pay it back over time, typically at a fixed interest rate. That fixed interest rate means your monthly payment will be consistent over the term of your loan. In a rising interest rate environment, it may be easier to factor a fixed payment into your budget.
The other option when it comes to tapping your home’s equity is a home equity line of credit, or HELOC.
In contrast to home equity loans, HELOCs offer a revolving line of credit to tap as needed -- much like a credit card. You’ll only pay interest on the cash you’ve borrowed during the draw period, but, usually at a variable rate. That means your monthly payment is subject to change as rates rise.
Both home equity loans and HELOCs use your home as collateral to secure the loan. If you can’t afford your monthly payments, you could lose your home -- this is the biggest risk when borrowing with either type of loan.
Best ways to use your home equity responsibly
Receiving a lump sum of cash with no restrictions could tempt you to spend extra money or complete extra renovations, but you don’t want to be on the hook for paying back money you don’t need in the first place. It’s important to be prudent with your home equity funds and use them primarily for your home renovation.
“Tapping home equity should be reserved for major, one-time expenses such as large renovations or repairs, like a new roof,” says Greg McBride, chief financial analyst at Bankrate, CNET’s sister site. “This is borrowing, which must be repaid with interest, and it puts your single largest asset on the line in the event of default. Any equity you tap is borrowing capacity that won’t be available later and less cash in hand when you eventually sell,” McBride says.
Stick to remodeling: A home equity loan shouldn’t be used to pay for nonessential items such as a vacation or a lavish party. These aren’t responsible uses of funds that are secured by your home. Put another way, a vacation isn’t worth having your home foreclosed on if you can’t pay your loan for any reason.
Be careful of overspending: If you’re offered a high credit limit, you don’t need to take it. Taking out only the amount you need for your specific project will help you stay on budget. Having access to excess funds will only entice you to spend it.
Select the right remodeling projects: Some home improvement projects will add more value to your house than others. Adding a home office, for example, will result in a better return on your money when you sell your home versus putting in new windows. Consider not just what you want right now, but what will appeal to future buyers because the projects you choose will impact the resale value of your home.
Deduct your interest: Work with an accountant to make sure your interest is properly deducted from your taxes, as it can save you tens of thousands of dollars over the life of the loan. Or, if you do your taxes yourself, make sure to deduct your interest and file an itemized tax return instead of a standard deduction.
Pros of using home equity for remodeling
There are good reasons to justify taking out a home equity loan to remodel or renovate your house, not the least of which is enjoying the improvements you’ve made to your most important investment. But there are practical reasons, and benefits, that warrant tapping into your home equity.
The interest is tax deductible
As mentioned earlier, the interest on your home equity loan is tax deductible, provided that you use the money to “buy, build or substantially improve your home,” according to the IRS. However, there are limits to how large a loan you can take out in order to qualify.
Interest rates are lower than other loans
Home equity loans have low interest rates compared with other types of loans such as personal loans and credit cards. Current home equity rates are as high as 8.00%, but personal loans are at 10.81%, according to CNET’s sister site Bankrate.
You receive a lump sum at a fixed rate
With a home equity loan, your interest rate will be fixed, so you don’t have to worry about it going up in a rising interest rate environment, such as the one we’re in today. Your monthly payments will always be consistent and won’t increase or decrease as they do with a HELOC.
Renovations increase the equity in your home
Also as mentioned above, it matters what type of renovation projects you undertake, as certain home improvements offer a higher return on investment than others. For example, a minor kitchen remodel will recoup 86% of its value when you sell a house compared with 52% for a wood deck addition, according to 2023 data from Remodeling magazine that analyzes the cost of remodeling projects.
Cons of using home equity for remodeling
While there are advantages to home equity loans for loan repairs, there are also downsides to using them. If property values decline when a recession or other disruptive economic event occurs, the improvements won’t end up increasing your home’s worth the way you had planned because your home will have gone down in value overall.
You can lose your home
Your home secures the loan. If you miss payments or can’t pay back your loan in full for any reason, you can lose your house to your lender or financial institution, which will then use the proceeds from the sale to pay itself back what you couldn’t.
Loan limits for interest deductions
Your loan interest is only tax deductible up to $750,000 for joint filers or up to $375,000 for single filers.
Home values could fall
While property values have skyrocketed over the last two years, if house prices drop for any reason in your area, your investment in improvements won’t have actually increased your home’s value. When you end up owing more on your mortgage than what your home is actually worth, it’s called negative equity or being “underwater” on your mortgage.
Home equity loan vs. HELOC: Pros and cons
HELOCs are similar to home equity loans in that you can deduct the interest from both types of loans from your taxes, but there are a few key differences. A HELOC is often better when you want more flexibility with your loan.
Using a home equity loan for home improvements
Pros
Your interest rate is fixed: With a fixed-interest rate you don’t need to worry about your payments going up or paying more in interest over time. Your monthly payment will always be the same, no matter what’s happening in the economy.
You receive a lump sum: All of the cash from the loan is distributed to you upfront in one payment, so you have access to all of your funds immediately.
Cons
You have to use all the funds: With a HELOC, if you don’t end up needing your total credit limit, you’re not required to spend it all. But with a home equity loan, you receive all the money at once, whether you need it or not. That means you also have to make payments on the total loan amount from the beginning of the loan term, which will likely be higher than the interest-only payments you can make during the decade-long draw period of a HELOC.
Your interest rate remains fixed when rates go down: If interest rates go down for any reason, you are stuck with your rate and can’t change it.
You could lose your home: If you are unable to afford your monthly payments, you could lose your home.
Using a HELOC for home improvements
Pros
You have a revolving line of credit: A HELOC functions more like a credit card that you access whenever you need funds, which offers you more flexibility than a home equity loan.
You can make interest only-payments: You can make interest-only payments during the draw period of your HELOC, the set time period which you can take money from your line of credit (usually a period of 10 years), which means you can borrow a large amount of money for an extended period of time while only making minimum monthly payments.
You can convert a HELOC into a home equity loan: If interest rates start rising, you have the option to convert your HELOC to a fixed-rate HELOC or a home equity loan to help save you money. (You can’t change your interest rate with a home equity loan.)
Cons
Variable interest-rates can be too much: Your monthly HELOC payment will go up and down depending on current interest rates trends, so your budget must be flexible enough to allow for the possibility of higher payments at any time.
Monthly payments increase after the draw period: After your draw period is over you are required to make payments on both the interest and the principal balance of your loan, which means your monthly payment will increase significantly when your repayment period begins. A typical HELOC repayment period is 20 years.
Your home could be repossessed: Your home secures the loan. Just like a home equity loan, you need to put your house up as collateral to secure the loan, so your bank or lender can repossess your property if you fail to make your payments.
Alternatives to using your home equity for home improvements
It bears repeating: You should only borrow against your home for important life expenses such as home improvements and renovations or for college tuition -- expenses that are an investment in your future and that add value to your property and life, not nonessential costs such as that “much needed two-week vacation.”
If using a home equity loan for remodeling doesn’t make sense for your particular situation there are alternative financing options to consider. As with all forms of credit, make sure you can responsibly manage the amount of money you’re borrowing.
Cash-out refinance: A cash-out refinance is a good option for homeowners looking to lock in a lower interest rate on their mortgage. A cash-out refi provides you with a lump sum of cash just like a home equity loan, but it replaces your current mortgage so you only have to make one monthly payment, while also saving money on interest over the course of your mortgage. Interest rates, however, typically have to be lower than your mortgage rate for this option to make sense.
Personal loans and credit cards: Personal loans and credit cards tend to have higher interest rates than home equity loans or HELOCs, but you don’t have to put your house up as collateral to secure the funds.
The bottom line
Home equity loans can be a cost-effective way to borrow against your home’s equity when it comes to remodeling, because they’re tax deductible and provide the means to increase the value of your home. But before you decide on how to fund your next home remodeling project, consider the pros and cons of a home equity loan and a HELOC to determine which one best suits your needs.
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