Benefits Of Using A Home Equity Loan For A Remodel And What To Consider

Getting funds for a major home improvement can be a key step in completing a home remodeling project. Without making adequate preparations and having a sufficient renovation budget, you may be left with an unfinished project that can even make spaces unlivable depending on the circumstances.

You could always decide to wait and save up enough cash, or you could use a credit card – which is likely to carry a high interest rate. However, you may enjoy the most financial benefit by leveraging your home’s equity. If you have enough equity built up in your home, you might be able to cover the entire cost of your project, from a kitchen remodel to a finished basement.

Let’s walk through exactly how you can accomplish your remodeling goals with a home equity loan for a remodel. We’ll also uncover the pros and cons of this financing strategy as well as a home equity line of credit (HELOC) – which has some similarities to a home equity loan – and we’ll explore some alternatives if neither option seems suitable for your needs and financial situation.

At A Glance: Using A Home Equity Loan For A Remodel

• Home equity loans are a type of financing that can cover expensive home improvements with a low, predictable interest rate.
• If you decide to leverage your home equity for a remodel, you can get funds through a home equity loan in the form of a lump sum, or you can get a HELOC with revolving credit and use it as needed.
• When using a home equity loan for a renovation, your project should add value to your home without exceeding your budget.

How Does A Home Equity Loan Work For Home Improvements?

As you make payments on your mortgage each month, you gradually build equity in your home that you can tap into. Once you have enough equity, you can take out a home equity loan worth up to potentially 85% of your home’s equity, which is the value of your home minus the amount you still owe on your mortgage. These funds can go toward a home improvement project or other significant expenses. The amount you decide to borrow must be paid back as a monthly payment along with your mortgage.

Understanding A Home Equity Loan Vs. Home Equity Line Of Credit

A home equity loan is a type of second mortgage. This loan option is suitable for extensive home improvement projects that you can closely gauge the total cost of, since you’ll have to pay back in full the amount you borrow. Using a home equity loan for a remodel can help you save on payments and benefit from a competitive, fixed interest rate. So, instead of paying a different amount each month due to fluctuating rates, the interest rate you receive at the time of approval will remain in place until you’ve paid the loan off.

Keep in mind that this type of financing uses your home as collateral, meaning your lender can repossess your home through foreclosure if you stop making payments. Take the time to determine how much you need in funds for remodeling and what you can afford to pay each month.

A home equity line of credit (HELOC) is likewise a type of second mortgage, but it lets you borrow from your home equity as needed, which can work out well if you’re not sure how much money you’ll need to complete your project. A HELOC can be ideal for smaller home improvement projects because it lets you borrow from a line of credit for up to 10 years. HELOCs usually come with a variable interest rate that may increase as time passes, but the good news is that you can make interest-only payments on this type of loan for a period of time. Please note that Rocket Mortgage^® doesn’t offer HELOCs at this time.

The right method for leveraging your home equity will ultimately depend on your financial situation and the projects you want to complete. Be sure to compare the pros and cons of each method before committing to one.

Pros Of Using A Home Equity Loan For Remodeling

Using a home equity loan to remodel your home can have several advantages. We’ll delve into the pros of home equity loans and how you can get the most out of one.

The Ability To Borrow More Money

Home improvement projects tend to be expensive and can come with unpredictable costs. However, using the home equity you’ve built up over time might be the best way to go about covering the costs in full. You’ll likely have the opportunity to borrow more money than you could with a personal loan or credit card, especially if you’ve paid down a significant amount of your mortgage’s principal balance, your home’s value has risen substantially or both.

Access To A Low Interest Rate, Relatively Speaking

Compared to other types of financing such as a personal loan or credit card, home equity loans offer an interest rate that’s low and closer to the rate you would get with a traditional mortgage. That’s because lenders consider home equity loans less risky since they use your home as collateral if you can’t make your payments. To save more money over time and obtain the lowest possible interest rate, you’ll likely need a strong credit score of 740 or higher, but it’s possible to be approved for a home equity loan with a lower credit score.

Increasing Your Home’s Value

Investing the money from your home equity back into your home in the form of a home remodel can increase your property’s worth and pay off in a meaningful way when you decide to sell. With desirable renovations, you can attract more interest from buyers when you put your house on the market, and those who wish to buy your home could even end up in a bidding war that results in you netting a higher profit.

Home improvements, which can include upgrading a kitchen, replacing the flooring or replacing old systems such as an HVAC, are popular choices and can mean less upkeep for the new owner.

Writing Off Interest On Taxes

Usually, you can deduct the interest paid on a home equity loan from your annual federal income tax return. To qualify for this deduction, you must use the loan money to buy, build or make substantial improvements to your home. Married couples filing jointly can claim an interest deduction on up to $750,000 worth of a loan if they qualify for the deduction, so be sure to consult your financial advisor to find out your options.

A deduction of this nature gives homeowners a chance to save money compared to forms of financing where no write-off is available.

Cons Of Using A Home Equity Loan For Remodeling

It’s important to also keep in mind the drawbacks that come with a home equity loan.

The Risk Of Foreclosure

Because a home equity loan is a secured loan, your home serves as collateral. Failure to make your loan payments can initiate a foreclosure by the bank that’s responsible for your loan. That way, the lender can pay off what you couldn’t within the agreed-upon terms. With an unsecured loan, such as a credit card, your home won’t be on the line.

Before committing to a home equity loan, make sure you’re fully capable of making the monthly payments on top of your mortgage and any other monthly bills you have.

A Possible Decrease In Home Value

The housing market is unpredictable, and if house prices drop significantly in your area, your investment in renovations may not increase your home value. If the price of houses continues to plunge, you could even end up with negative equity or what’s known as being “underwater” on your mortgage. That means you would owe more on your loan than your home is worth.

Some projects don’t increase a home’s value. That’s because the updates to the home become outdated by the time you decide to sell, which could mean you’ll profit very little, if at all, when you sell your home.

Added Fees And Closing Costs

Home equity loans require closing costs since they’re a second mortgage you must pay back out-of-pocket. Closing costs can include lender fees such as the origination fee and fees for the appraisal, credit report, certain documents and a title check. The amount you owe in closing costs will typically be 2% – 5% of the total amount borrowed. For example, a $50,000 home equity loan will likely require paying $1,000 – $2,500 in closing costs. 

Some lenders may waive closing costs on home equity loans, at the expense of the borrower being stuck with a higher interest rate.

The Potential To Borrow More Than Is Necessary

In the event you take out a home equity loan for a home improvement, accurately determining the amount of funds you need is essential since you’re locked in to paying the entire amount you borrow. Sometimes, lenders have minimum borrowing requirements. If you have an unused portion of your loan and want to pay it off early, you might incur a prepayment penalty charge from your lender.

Let’s say, for example, you take out a home equity loan of $50,000 for a home improvement project but only end up using $40,000. You still have to pay that leftover amount of $10,000, along with the interest on it. For this reason, some borrowers decide to go with a home equity line of credit (HELOC), which allows you to only pay back and pay interest on the part of the loan you actually use.

HELOCs Vs. Home Equity Loans For Home Renovation

While you tap into your home equity with both a HELOC and a home equity loan, the two differ in their repayment terms and they typically differ in whether they have a fixed or adjustable interest rate. In most cases, the interest rate on a home equity loan is fixed, while the opposite is true for HELOCS. Keep in mind that a home equity loan involves one lump sum of money that must be paid back in full, whereas with a HELOC, you must only pay what you decided to borrow, plus interest.

Think about the following pros and cons of using a HELOC for a home improvement project and whether you may benefit more from leveraging this kind of financing.

Pros Of A HELOC For A Remodel

Here are a few ways you can benefit from using a HELOC for a home remodeling project:

• You hold a revolving line of credit. Similar to taking from a credit card, a HELOC only requires you to pay back what you use, plus interest. This can offer more flexibility than a home equity loan, which you have to pay back in its entirety. The HELOC borrowing method comes in handy for unexpected expenses as well.
• You can make interest-only payments for a while. During your HELOC’s draw period, which is a term of up to 10 years when you can take money from your line of credit, you can make interest-only payments and pay a certain minimum each month.

Cons Of A HELOC For A Remodel

Here are the ways you might be at a financial disadvantage if you choose a HELOC for a home remodeling project:

• Variable/adjustable interest rates can be risky. Depending on the direction that interest rates move in, your monthly HELOC payment amount could rise, putting a strain on your budget.
• Monthly payments increase after the draw period. Once your draw period of up to 10 years ends, you’re required to begin paying on both the loan’s interest and principal, and your payments will increase significantly.
• Your house is used as collateral. Because the lender uses your home to secure the loan, you could lose your home if you’re unable to make on-time payments.

What To Consider Before Using A Home Equity Loan For Your Remodel

Before settling on a home equity loan, it’s important to be certain that this is the wisest strategy for your situation. Otherwise, you might take on unnecessary costs. Use the following tips as a guide to get the most out of your home equity loan for a remodel:

• Choose a project that adds value. Since tapping into home equity puts your home on the line, it’s important to guarantee that your projects will yield a return on your investment, as would likely be the case with the addition of a room or new hardwood floors. Investments that don’t add value make it harder to earn a profit when you’re ready to sell your home.
• Don’t overspend. A lender may offer you a rather large loan, which can be good, but it doesn’t necessarily confirm your ability to comfortably afford the amount you’re offered. Establish a budget that factors in your new monthly payments before committing to a home equity loan of a certain amount, and don’t forget to factor in unexpected expenses.
• Deduct interest. As already explained, you can deduct up to a certain amount of interest on the home equity loan you use for remodeling – potentially saving thousands of dollars.

Alternative Options To Home Equity Loans For Renovations

Home equity loans and HELOCs aren’t the only ways to pay for major home renovations. Here are some alternatives to consider:

• Personal loan: Personal loan funds usually arrive within a few days of loan approval and can cover all or a large portion of the expenses associated with a major project, such as a home remodel. The interest rate on a personal loan can be as high as 36%, but you’ll have a shorter repayment period than you would with a second mortgage. Since most personal loans are unsecured, meaning they don’t require any kind of collateral, you likely won’t risk losing anything tangible if you fail to pay the loan back on time.
• Cash-out refinance: A cash-out refinance will let you take cash from your home equity and use that cash for your remodel. It’s also possible with a cash-out refinance to get a lower interest rate and a longer or shorter repayment term on your new home loan, which replaces the original loan when you refinance. Unlike with a home equity loan or HELOC, you won’t have a second mortgage to pay with a cash-out refinance.
• Credit card: For smaller home improvements, a credit card can give you sufficient funds interest-free for a period of time. A 0% APR credit card typically can allow the cardholder up to 21 months to pay off their balance before interest begins accruing. A credit score of 670 or higher is typically required for this type of credit card.

The Bottom Line: A Home Equity Loan For A Remodel Could Work For You

While home improvements are often costly, you have multiple ways you can cover the expenses that come with them. One of the most practical ways is to use the equity you’ve built up in your home and do so with a home equity loan. Get started on financing your home remodel by finding out how much you can borrow and comfortably afford in addition to your mortgage. Remember to factor in the fees that come with second mortgages and the possibility that your home remodel might require more money than you originally thought.

With the right steps and financial preparation, you can enjoy your new home renovations and possibly sell your home at a higher price.

Start the application process with Rocket Mortgage and get started on building equity in a new home today.