HELOCs: What They Are & How They Work for Renovating
A comprehensive guide to understanding Home Equity Lines of Credit (HELOCs) and how they work for home renovations, as well as a look at the alternatives.
A Home Equity Line of Credit, or HELOC, lets you take out a line of credit using your home equity. You can use the line of credit for any major purchase and draw the money whenever you need it, allowing you to initially only pay interest on the money you’ve drawn, rather than the full loan amount.
Often homeowners use HELOCs to finance major renovation projects, as the interest rates are lower than they are on personal loans and credit cards.
But while they are a common renovation financing method for home improvement projects, the reality is that for many homeowners there are better alternatives available.
In this guide, we are going to take a look at what HELOCs are, how HELOCs work for financing renovations, how much you can borrow, and the alternative financing options for home renovations.
Specifically, this guide will cover:
We’ll start off by saying that HELOCs can be an amazing way to finance a home remodel - if you have enough equity.
But the reality is that most homeowners, especially those who’ve purchased their home in the last 10 years - won’t have enough equity to finance their home renovations with a traditional HELOC. And we’ll explain why.
A standard HELOC might not be the best way for you to finance your renovation.
Speak to a RenoFi Advisor today to talk through your options.
What is a HELOC?
Home Equity Lines of Credit, also known as HELOCs, allow you to take out a line of credit using the equity you’ve built up in your home. However, unlike credit cards, with HELOCs you are borrowing against your property, which is being used as collateral. HELOCs are sometimes called a “second mortgage” as they are in second position to your first mortgage on your home.
HELOCs allow you to draw smaller money from your line of credit when you need it, with a set maximum amount you can draw in total. HELOCs offer more flexibility than home equity loans, which require you to take out a lump sum of home equity all at once.
Like credit cards, HELOCs can be used to finance anything - from college tuition payments, to renovation projects, to medical expenses. HELOCs are even used to pay off high interest debt.
In this article, we’ll be talking about using HELOCs to finance renovation projects, one of the most common uses for HELOCs.
How Much Can You Borrow with a HELOC?
Every lender has slightly different requirements for HELOC borrowing amounts, based on different factors.
However, the main factor that will determine your maximum line of credit is your Combined Loan-To-Value (CLTV) Ratio. Each lender will offer a different, maximum CLTV, although generally it will fall between 75% and 95%.
A CLTV ratio is simply your mortgage, combined with your HELOC (second mortgage), divided by the value of your home.
For example, if your home is worth $400,000, you owe $300,000 on your mortgage, and you’d like a $50,000 line of credit, your CLTV ratio would be 87.5%
($300,000 + $50,000)/$400,000 = 0.875
CLTV isn’t the only factor that will determine your borrowing amount. Banks and credit unions will use things like credit score, income, expenses, and employment history to determine your “creditworthiness,” to see how much you can borrow and what your interest rate will be.
HELOCs vs Home Equity Loans
HELOCs and home equity loans are both considered “second mortgages,” as they are in second position compared to your first mortgage, and you’re borrowing from your home as collateral.
However, HELOCs function as a “line of credit,” like credit cards, where during the draw period, you can draw smaller amounts of money only when you need it. With home equity loans, you’re required to borrow the entire loan amount in a lump sum, and begin paying it off almost immediately.
People sometimes prefer HELOCs because they are more flexible if you’re not sure how much money you’ll end up needing, but want the freedom to tap into your line of credit at any time.
Home equity loans are normally fixed-rate, and HELOCs are generally variable-rate, which is another difference between the two options.
How Does a HELOC Work?
HELOCs generally have two phases - the draw phase and the repayment phase. The draw phase generally lasts around 10 years and is the time when you can use your line of credit whenever you’d like.
During the draw phase, you have the option to pay interest only, but you can also amortize the loan (pay it off) sooner. You can access your funds through online transfers or some banks will even offer credit cards connected to your account.
After this initial draw phase, you can no longer access your funds and you are required to start paying back your equity to the lender, along with interest payments. Repayment periods are generally between 15 and 20 years.
HELOCs normally have minimal to no closing costs.
Fixed-Rate vs. Variable-Rate HELOCs
HELOCs have variable rates, rather than fixed rates. This means that your interest rates will fluctuate depending on the market as you’re paying back your loan.
While it is uncommon, some banks will offer fixed-rate HELOCs, or partial fixed-rate HELOCs, where you can turn a portion of your HELOC balance into a fixed-rate loan once you start to draw from your line of credit.
Oftentimes, these fixed-rate HELOCs will have higher starting interest rates than variable-rate HELOCS, or additional fees, but it depends on the lender.
There are a few requirements that you’ll need to qualify for a HELOC, however, they will vary depending on your lender.
- Credit Score: Most lenders will require a credit score of at least 680 when applying for a HELOC. Some lenders will lend to homeowners with a credit score as low as 620, so it’s important to evaluate options from multiple lenders if you don’t have great credit.
- Tappable Equity: In order to draw money from your home, you will need to have 15 to 20% equity in your home, and lenders will cap your borrowing amount between 75 and 90% of your Combined Loan-to-Value Ratio (CLTV). For example, if your home is worth $500,000, but you’ve only paid off $75,000, or 15% of that, you may not qualify for a HELOC.
- Debt-to-Income Ratio (DTI) of 43% or Less: Your DTI is all of your combined monthly debt payments divided by your gross monthly income. While some lenders will allow up to a 50% DTI, 43% is the standard maximum.
- Stable Income: Most lenders will require proof of a steady, stable income to qualify for a HELOC.
The Pros & Cons of a HELOC for Renovations
As with any mortgages or renovation loan option, there are pros and cons to HELOCs:
- Flexibility to draw only what you need
- Smaller payments during the draw period when typically only interest is paid
- Lower interest rates than personal loans or credit cards
- No interest payments on money you don't end up needing
- You may write off some interest as a tax deduction if it’s being used for renovation project; check with your accountant
- Not enough borrowing power for most new homeowners
- Monthly payments often increase after draw period, which is shocking for some homeowners
- Takes much longer to close than a personal loan, especially during the pandemic in a low rate environment
- Mostly variable interest rates, which can be unpredictable
- It will take you longer to pay off your home
HELOCs vs Cash-Out Refinances
HELOCs are not part of your first mortgage and your first mortgage is not affected by taking out a HELOC. Cash-out refinances instead replace your first mortgage, offering a lump sum from your home’s equity rather than a line of credit..
As opposed to a traditional refinance, where you’d replace your mortgage for a new one with the same balance (and hopefully a better interest rate), a cash-out refinance allows you to take cash out of the home equity you’ve built up, and replaces your current mortgage for a new one with a higher balance.
Mortgage rates are typically lower with cash-out refinances than interest rates on HELOCs. Therefore, cash-out refinances are often popular when the rate environment is unusually low, as people can refinance into a much lower rate while also taking out money to use on a home improvement project.
Cash-out refinances have similar requirements to HELOCs when it comes to tappable equity. If you’re an equity-light new homeowner, you’re going to run into the same limit of only being able to take out 75% to 85% of your home’s equity, even less than with a HELOC, which sometimes isn’t enough for home improvement projects.
Just like HELOCs, cash-out refinances come with potential tax deductions if the money is going toward substantial home improvements, making them a common financing option for major renovations.
Overall, cash-out refinances can be a great option for homeowners who want to lock in a lower rate on their first mortgage. The downside to cash-out refinances is their high closing costs (2-5%) when compared with HELOCs.
Introducing RenoFi HELOCs - A Better Alternative to Standard HELOCs
If you’re considering a standard HELOC to pay for a home renovation project, the key thing you need to know is that another option exists for equity-light homeowners that offers more borrowing power: RenoFi HELOCs.
These alternative HELOCs are a new type of HELOC that allows homeowners to borrow based on their after renovation value - ie. their home value after a renovation. This factor dramatically increases borrowing power for most homeowners. On average, homeowners can borrow 11x more with a RenoFi HELOC than with a traditional HELOC option.
The main things you need to know about RenoFi HELOCs:
- Loan amounts from $25,000 to $500,000
- Low, variable rates
- 10 year interest only period, followed by 15-20 year amortization
- Ability to borrow up to 90% of the after renovation value
- Line of credit that can be drawn down and paid back at interest-only for 10 years
Why You Shouldn’t Use A Standard HELOC for Home Improvements (& Consider a RenoFi HELOC instead)
If you’ve built up equity in your home (that’s the difference between what it’s currently worth and the amount you owe on your mortgage), then tapping into this by using a HELOC can be a great way to pay for a renovation.
But renovating is expensive. In fact, it’s not uncommon for an entire renovation wishlist to cost $100,000 or more, and this means that HELOCs aren’t available to recent homebuyers who haven’t yet built up equity.
Just take a look at the example below showing tappable equity on a $400,000 house with a 15% down payment.
As you can see, after 10 years these homeowners still have barely built up enough equity to complete their home renovation project with a HELOC.
This is because traditional HELOCs factor in your home’s current value, while RenoFi HELOCs factor in your home’s future value, after a renovation.
Here’s an example that explains how a RenoFi HELOC offers so much more borrowing power:
The Jenkins family is planning a home improvement project that will cost $250,000.
They purchased their home five years ago and want to do the two-story addition and kitchen remodel they’ve been discussing since they moved in.
Their home is currently worth $500,000, and they owe $400,000 on their mortgage. It is expected that the value of their house will be $750,000 after the renovation is complete.
Let’s compare how much they could borrow with a traditional HELOC vs a RenoFi HELOC:
|Home Equity Line of Credit||RenoFi Home Equity Line of Credit|
|90% Current Home Value||90% After Renovation Value|
This is more than sufficient to finance the $250,000 remodel that’s on the cards.
But you’re probably left wondering how the Jenkins’ borrowing power suddenly increased by so much…
It’s because RenoFi HELOCs allow you to borrow based on what your home’s value will be after your renovation is complete. Essentially, you’re tapping into that increase in equity right now.
The Jenkins’ are making some big improvements to their home, and its value is going to increase. But traditional HELOCs don’t acknowledge that.
Therefore, if you’re a new homeowner, or even just a homeowner that needs more borrowing power, we’d recommend checking out RenoFi HELOCs.
Try the RenoFi Loan Calculator to see how much you can borrow.
Or, if you’d like to explore your options, contact a RenoFi Advisor to learn more.
Home Equity Loan & HELOC FAQs
Home equity loans and lines of credit can be confusing, we get it.
To help you out, here are answers to some of the most commonly asked questions about these two renovation financing options.
What is a home equity loan?
What is a home equity line of credit (HELOC)?
Should you use a home equity loan to remodel?
Does a HELOC make sense for renovations?
How much money can you borrow with a home equity loan?
What type of loan is best for home improvements?
What if I don't have enough equity? How can you finance a home remodel without equity?
Is a home equity loan the same as a home improvement loan?
No, a home equity loan lets you tap into your home’s equity to borrow a lump sum that’s often used to pay for home improvements.
But they can also be used for other things, and common uses include covering education or medical costs.
These are a specific type of loan; a financial product that’s been designed to allow homeowners to borrow against the equity that they have built up in their homes.
A home improvement loan, on the other hand, can refer to anything. It could be any type of loan that is advertised towards homeowners who want to borrow to finance a remodeling project, so it’s really important that you do your research to understand what that ‘home improvement loan’ that you’ve been offered really is.
What many don't realize is that these are often just high-interest personal loans that are marketed under the name of ‘home improvement loans,’ rather than being a specialist financial product.
Other times, the term ‘home improvement loan’ is used to refer to what’s known as a home renovation loan, a loan that lets you borrow based on your home’s after renovation value.
What are the disadvantages of a home equity loan?
The main disadvantage of taking out home equity loans for home improvement projects is that your borrowing power is limited by the amount of tappable equity that you have available.
If you’re a recent homeowner who has not built enough equity, an alternative method of financing such as a RenoFi Loan could help you to borrow enough to undertake your full renovation wishlist.
Are there closing costs on a home equity loan?
Yes. Closing costs are highly variable, but are typically between $500 and $1,000. The closing costs on home equity lines of credit may be lower.
Common closing costs include:
- Application fees
- Loan origination and underwriting fees
- Appraisal fees
- Title search and escrow fees
- Credit report fees
Whilst these closing costs are typically lower than on a first mortgage, these can still amount to a noticeable sum of money on larger loans.
Do I have enough equity for a home equity loan or HELOC to finance a remodel?
Calculating whether or not a home equity loan could finance your remodel is simple and straightforward.
- Determine how much $ you need to borrow to cover the cost of your remodel.
- Multiply your home’s current value by 90%. (The maximum you can borrow against with a home equity loan is 90% of your home’s value.)
- Deduct your outstanding mortgage balance from this figure.
This will give you an estimate as to how much you could get from a home equity loan or HELOC.
Is this enough to cover the cost of your renovation?
If it’s not (which for many homeowners will be the case), consider a RenoFi Loan that lets you borrow based on your home’s after renovation value and significantly increase your borrowing power.
Which is better to finance a renovation, a fixed rate or a variable rate?
If you plan on paying off the loan over many years, the peace of mind of locking in the rate and knowing your exact payment means the Home Equity Loan is likely the right choice. If you’re not sure what the total cost will be, or are going to be completing your remodel in phases and want to draw on the money as and when you need it, a HELOC might be a better choice.
That said, if you have only recently bought your house and do not have sufficient equity to pay for the renovation work you want to carry out, neither of these will be the best option.
Check out RenoFi Loans to see how you could borrow against your home’s future equity (based on your home increasing in value after a remodel) today.
Is the interest on home equity loans and lines of credit (HELOC) tax-deductible?
Maybe you’ve heard that, in some cases, you can deduct the interest paid on home equity loans or lines of credit on your tax return?
Typically, the interest on these loans is tax-deductible when:
- Your loan is secured against your home.
- This is used to carry out substantial improvements that add value, prolongs its useful life, or adapt it for a new use.
- The loan amount doesn’t go above $750k for a married couple or $375k for a single borrower.
For most homeowners tapping into their home’s equity to finance a renovation, they will be able to deduct this on their tax return. RenoFi Loans are also tax deductible. Please always check with your accountant.
What alternatives exist to home equity loans and HELOCs to pay for a remodel?
How do I know if a RenoFi loan is right for my project?
The RenoFi team is standing by to help you better understand how RenoFi Loans work and the projects they are best suited for. Have a question - Chat, Email, Call now...