In 2018, John Sewell and his wife installed floor-to-ceiling windows and built a larger living space in their 1950s ranch in Jackson, Mississippi. This year, they added a new driveway, landscaping, a new front door, a porch, and even painted the house — all thanks to a line of credit backed by the equity in the home.
And while the Sewells haven’t had their house appraised since they bought it in 2009, they are confident these home improvements will increase its value. Once they are ready to sell, they will likely have recouped their investment, and then some.
They were able to afford the renovations because they held equity in their house, meaning they owed less on their mortgage than the property was worth.
Home equity is calculated by subtracting the outstanding amount of your mortgage from the current value of your home. If you hold equity in your home, then you can borrow against it, using the home itself as collateral.
You can apply for either a home equity loan or a home equity line of credit, also known as a HELOC. The Sewells chose the latter, and were able to get a HELOC of $50,000 with a 4% interest rate.
A home equity loan is paid to you in a lump sum, whereas a HELOC is a predetermined line of credit that can be tapped over a given period. You can apply for either one at banks, credit unions and even online lenders; a good place to start your search is with the issuer of the mortgage on your house, which may give you especially favorable conditions.
While you can use a home equity loan and a HELOC for similar goals or expenses, they have different features and can be useful for different types of projects.
HELOCs, because they are revolving credit lines that remain open for up to 25 years, are a good choice for ongoing renovations, like what the Sewells did. In that sense they are like a credit card, but with far lower interest, since they are secured by a tangible asset — your home, which the lender can repossess if the borrower defaults — while credit cards are unsecured and therefore riskier for a lender.
Both home equity loans and HELOCs are also useful to pay off higher-interest debts or tackle large expenses, but when used for home renovations they can increase the value of your home.
Generally speaking, the more equity you have in your home, the more money you’ll be able to borrow, up to a maximum of usually 85%. That amount is determined by factors including your income and creditworthiness, as well as the value of the property.
This is when you should consider tapping into your home equity — and when you should not.
“Utilizing a relatively low-interest loan, especially if it is to cover the cost of a major home improvement or renovation, could be a smart financial move,” Elliot Pepper, CPA, a co-founder of Northbrook Financial, told us.
The interest on both types of home equity products can be tax-deductible, if the funds are used for home improvements. The IRS is pretty specific as to what meets the definition of home improvement here; home additions, a new roof and replacing your HVAC are some good examples, says Lindsay Martinez, a Certified Financial Planner at Xennial Planning.
In any case, borrowing against home equity is a smarter way to fund a home improvement than using a personal loan.
Home equity loans and lines of credit can also be used to cover emergencies, especially in today’s challenging financial environment. “Many people are very stressed from a liquidity perspective, and their only real option may be to obtain a fixed rate home equity loan,” Michael Caligiuri, CFP, founder and CEO of Caligiuri Financial, also told us.
That should be a last-ditch option, though. If you have the financial leeway, you should focus on building an emergency fund to deal with exactly that sort of occurrence.
Using the money from a home equity loan or line of credit to pay off debt with a higher interest can also be a good idea. Some examples of high-interest debt include car loans and credit card debt. The annual percentage rate on credit card debt can be more than 20%, while borrowing from home equity is far cheaper — as low as 3% for borrowers with high credit scores, thanks to the Federal Reserve keeping interest rates low to help stimulate the economy.
When Not to Use Home Equity
The one thing experts say you should not use a home equity loan for is personal expenses, such as “buying a boat, a fancy car, or paying for a wedding,” says Martinez. “You don’t want to risk your home on a splurge if you default on the payments,” she adds.
You also should be wary of tapping into home equity if you don’t have an emergency fund, or if you cannot count on a steady income.
It’s important to keep in mind that you’re using your home as collateral, and if you default on your payments, the lender can claim your home. you want to be confident in your overall financial health without biting off more than you can chew.
Especially as the economy remains hobbled by the pandemic, this is a time to focus on building your emergency fund and your retirement savings, and investing in things that will likely bring a return, like home improvements. Borrowing against home equity can be a smart way to do that.