2020 was a big year for home equity. The average homeowner with a mortgage saw their home equity grow to more than $200,000 thanks to a big increase in home prices, according to the Homeowner Equity Insights report by housing data firm CoreLogic.
At the same time, many Americans working from home realized a need to reconfigure their space, says Dr. Frank Nothaft, chief economist at CoreLogic.
Tapping into home equity “has enabled many families to finance the remodeling and addition to their home to accommodate these needs,” says Nothaft.
As more people realize working from home could stick around even after the pandemic, “they think ‘do I want to build this out? Do I want to finish the basement, or create an office?’,” says Craig Lemoine, director of the Academy for Home Equity in Financial Planning at the University of Illinois. “I do think some of the borrowing is that.”
If you’re considering drawing on your home’s equity for a renovation or remodeling project, here’s what you need to know.
Home Equity Options for Home Renovations
In general, there are three main ways to access your home’s equity: a cash-out refinance, a HELOC, or a home equity loan.
Every homeowner should first consider a cash-out refinance. A cash-out refinance replaces your original mortgage with one that’s worth more than you owe on your house, and you’ll be paid cash for the difference.
Rates for cash-out refinancing are favorable right now, so you may be able to get the funds you need for your home improvement and save on mortgage interest. Just remember that with a cash-out refinance, you will be resetting the terms of your mortgage, and will have to pay some out-of-pocket expenses like closing costs, appraisals, and origination fees.
If you haven’t refinanced at some point in the past year, rising mortgage rates could eventually diminish the appeal of that option. In that case, you might consider a home equity loan or HELOC, which have long been standby options for homeowners.
Home Equity Loan
A home equity loan works like a traditional loan. You’ll get a lump sum payment at the beginning of your loan term, and then have monthly payments until you repay what you borrowed (plus interest).
Home equity loans have a fixed interest rate, meaning you’ll lock in your interest rate at the beginning and it won’t change. This can be advantageous in a low-interest rate environment, like right now.
A home equity line of credit, on the other hand, works more like a credit card. It’s a revolving line of credit secured by your home, that you can access via checks, a debit card, or other means depending on your lender.
HELOCs have a variable interest rate, meaning the interest you owe will fluctuate over the course of your HELOC term, and is subject to change with the market. HELOCs traditionally work on a 30-year model, with a 10-year draw period and a 20-year repayment period.
During the draw period, you can spend up to the amount of your credit line (determined upon application), and then you have the entirety of the repayment period to pay back what you spend (plus interest).
What You Should Know About These Options
Before you consider any type of loan that uses your house as collateral, it’s important to understand you could lose your house if you fail to keep up with repayment. Both HELOCs and home equity loans — just like a new mortgage after a refinance — are secured by your home, so failure to repay could mean foreclosure by the lender.
With both home equity loans and HELOCs, in particular, you’ll need a good amount of equity in your home, and good credit, to access them.
A HELOC can be a good choice if you have ongoing costs, or don’t know exactly how much you’re going to spend on your remodeling project. But if you’re worried about rising interest rates, a home equity loan may make more sense for you.
Home Equity Loans for Home Improvement: Pros and Cons
Full amount received at the beginning
Can spend on anything
Fixed interest rate
Must take and repay full lump sum amount, even if your project ends up costing less
Fixed interest can be harmful in a high-rate environment
Secured by your home
HELOCs for Home Improvement: Pros and Cons
Spend as you go
Can spend on anything
Variable interest rate
Secured by your home
Set draw and repayment periods
How to Get the Most From Your Home Equity Loan or HELOC
With a home equity loan, what you see is what you get.
You’ll get your total borrowed amount upfront and then it’s up to you to spend how you please. A HELOC is a bit more varied. You’ll be able to use the funds from your HELOC up to the amount of your credit line until the end of your draw period (usually 10 years).
During all of that time, you’ll need to make sure you make your loan payments on time and in full to avoid any damage to your credit, or you’ll potentially face losing your house.
Alternative Home Improvement Options
While there are definitely other ways that you can finance home improvements, many homeowners will be able to secure greater funding by tapping into their home equity. That’s because your home is probably one of the largest assets you have.
Aside from a cash-out refinance, home equity loan, or HELOC, here are a couple other options you might consider, and what you should know before you do:
A personal loan for home improvement is an option, but it’s one of the worst ways to pay for home improvements. High interest rates, short repayment periods, and lower loan amounts all contribute to personal loans not being ideal for home improvements.
If you have the ability to pay for your project with cash up front, you’ll be able to avoid financing costs and debt accumulation. Just be careful of where you take that cash from. Don’t deplete your emergency fund or blow all of your other liquid savings on a project.
Credit cards may seem like an option to help pay for part of a project, but keep in mind credit cards have very high interest rates compared to other types of loans. It can make sense to pay for some of your renovation this way, especially if you find a credit card with a long introductory 0% APR period. Just make sure you have a plan to pay off your costs entirely within that intro period, or your lingering balance will be hit with a higher APR when that intro period ends.
Also be wary of spending near your credit limit on any credit card, 0% introductory period or not. High credit utilization can hurt your credit score. Most experts recommend only spending up to 30% of your credit limit each month to keep your score on the rise.
Most experts agree you should never touch your retirement savings except in case of emergency. Tapping into your retirement to fund a home project not only deprives your retirement fund of the money, but it also costs you in lost interest. That money that could be benefiting from compound interest, so be very thoughtful about pulling any money from your retirement accounts, and avoid doing so if you can.