You’ve probably heard of home equity loans and home equity lines of credit (HELOCs) - but how useful are they when it comes to financing renovations?
You can use a home equity loan or HELOC for kitchen and bathroom remodels, landscaping, new roofing and siding, and more.
Often homeowners use HELOCs to finance major renovation projects, as the interest rates are lower than they are on personal loans and credit cards.
Not only that, you can continually build equity as you live in your home and then access your home equity when you need it with a home equity loan or HELOC.
A home equity loan is an alternative to the HELOC, and there are several important differences between the two options.
In this guide, we are going to take a look at what home equity loans and HELOCs are, how they work for financing renovations, how much you can borrow, and the pros and cons to both of these options.
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.
Using Equity To Finance Home Improvements
Using equity to finance a home renovation project can be a smart move. But you need to understand how it works to be able to figure out your best financing option.
The bigger the difference between the amount you owe on your mortgage and the value of your home, the more equity you’ve got. And as you continue to make monthly payments, your mortgage balance decreases and your equity increases.
But your home’s value can go down, as well as up.
Property prices change regularly, and when the market is performing well and prices are on the rise, your equity will increase.
But when the market is down, this can decrease the value of your home and reduce your equity. In very rare circumstances, you could even end up with negative equity, which is where you owe more on your mortgage than your house is worth.
Before rushing into making a decision on how to finance your remodel using the equity in your home, you need to consider your options and understand the pros and cons of each of these.
So let’s start by looking at the different options that you’ve got for tapping into your home’s equity:
- Home equity loan
- Home equity line of credit (HELOC)
- Cash-out refinance
Here, we’re going to be primarily focusing on home equity loans and lines of credit, but you can learn more about refinancing in our ‘3 Reasons Why You Shouldn’t Use a Cash-Out Refinance for Renovations’ guide.
Let’s dive a little deeper into the differences between these and take a look at the pros and cons of each, before introducing you to an alternative method of financing your renovation: RenoFi Loans.
After all, choosing the wrong one can be a costly mistake or can massively limit your borrowing power.
Using A Home Equity Loan For A Remodel
A home equity loan (or second mortgage) lets you borrow a lump sum amount of money against the equity in your home on a fixed interest rate and with fixed monthly payments over a fixed term of between five and 20 years, much like your first mortgage except with a shorter term.
How much you can borrow depends on your home’s market value and mortgage balance (as well as your credit score, your income and other factors), but this will usually be between 80% and 90% of what it’s currently worth minus your existing mortgage.
As an example, if your home is worth $500k and your current mortgage balance is $375k, a home equity loan could let you borrow up to $75k. (90% multiplied by $500k, minus $375k)
These are secured loans that use your home as collateral, meaning that you could lose this in the event that you are unable to make payments.
Technically, you can use the lump sum of money that you get from a home equity loan for anything, but it is typically used for home improvement projects, paying for college, medical expenses, debt consolidation, business or wedding expenses.
Home improvement projects are the most common purpose, though, with the US Census Bureau’s Housing Survey confirming that approximately 50% of home equity loans are used in this way.
- They’re almost always fixed-rate loans with set terms, payments, and schedules.
- Once you’re approved for a loan, you get the full amount in one lump sum.
- You pay off the loan in fixed payments over the life of the loan.
- Interest rates are locked in. If a loan term is 5-30 years, the interest rate won’t change over the years.
- The interest rates are typically lower than other credit products.
- Fixed monthly payments make it easy to budget.
- The interest may be tax-deductible.
- Can be a good way to convert the equity you’ve built up in your home into cash.
- You can pay off the loan early and refinance the loan at a lower rates (as long as you go through the credit process again).
- Tapping all the equity in your home in one swoop can work against you if property values in your area decline. If real estate values decrease, the market value of your house could decline, and you could end up owing more than your home is worth.
- The home could be sold to satisfy the remaining debt if the loan is not paid off or goes into default.
- If the loan goes into default, the bank may foreclose on or take back the home.
- If you relocate, and the home decreases in value, you could lose money on the sale of the home.
At A Glance
- Fixed, low interest rates
- Your home is at risk if you default on payments
Using A Home Equity Line of Credit (HELOC) For A Remodel
A home equity line of credit (also known as a HELOC) is a revolving line of credit that’s borrowed using your home’s equity as collateral. You can use this like a credit card, taking out how much you want (up to your limit) when you want. Just like home equity loans, HELOCs are secured and act as a second mortgage.
You’re being given access to a pool of cash that you can dip into and use as and when you need it. And just like a credit card, as you pay it back, it’s available again to draw.
You have a set length of time (usually 5 to 10 years) when you can draw on your line of credit. This is known as the draw period, and during this, payments that you make are only for the interest on the loan.
After the draw period ends, you’ll have a repayment period of a further 10 to 20 years, during which you make monthly payments that repay the loan amount and interest.
A HELOC is similar to a home equity loan in many ways, but there are two distinct differences:
- A home equity loan is paid as a lump sum, whereas a HELOC gives you a revolving line of credit. This means you only pay interest on what you’ve drawn and as you make payments and repay the line, it’s available to draw again should you need it.
- A home equity loan has a fixed interest rate, but a HELOC typically comes with a variable rate. The money from this can be used to pay for pretty much anything, but common uses include home improvements, education costs, consolidating other debt or similar.
Again, for this guide we’ll assume that it’s being used to finance a remodeling project.
To give an example of how a home equity line of credit works, let’s return to the previous example that we used:
- Your home is worth $500k and you’ve got an outstanding mortgage balance of $375k.
- Based on borrowing against 90% of your home’s current value, you could get a HELOC for up to $75k.
- But whereas with a home equity loan you would receive the full loan amount as a lump sum, in this instance it’s available as a revolving line of credit.
- That means if the project you want to undertake first costs $10k, you draw only this amount from the HELOC and thus only begin paying interest on that $10k.
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.
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
- While a home equity loan gives the borrower all the money in a lump sum, a HELOC allows the borrower to tap into the line only as needed.
- The line of credit remains open until its term ends.
- You know the maximum amount you can potentially borrow, which is the amount of the credit limit. You get flexibility to borrow as much or as little of that money as you need for your project. You pay interest only on the amount you draw (rather than the total in your credit line).
- Repayment terms are flexible, so you can pay it off or make minimum monthly payments.
- Interest may be tax-deductible if used for a major home improvement (consult your tax advisor).
- A HELOC is secured by an asset (your house). If you stop making the payments on the HELOC, you could lose your home.
- A HELOC has a variable interest rate. The minimum payment could increase as interest rates rise. This can make it difficult to determine the overall cost of a HELOC going into it.
- During the HELOC’s draw period, you still have to make payments, which are typically interest-only. The payments tend to be small during the draw period, but they do become substantially higher in the repayment period since the principal amount borrowed is now included in the payment schedule along with interest. The transition from interest-only payments to principal-and-interest payments can be quite drastic, so budget accordingly.
- A HELOC is revocable, like a credit card. If your financial situation worsens or your home’s market value declines, your lender could decide to lower your credit line or close it. In other words, your ability to access the money isn’t always guaranteed.
- Without discipline, you could overspend.
At A Glance
- Flexible repayment
- Can tap your line of credit on an as-needed basis
- Variable interest rates
- Your house is at risk if you default on payments
Tips for Choosing the Best Option for You
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.
Ask yourself about the purpose of the loan.
A home equity loan is good if you know exactly how much you need to borrow and how the money will be used. Once approved, you’re guaranteed that amount, and you receive it in full.
A HELOC is good if you’re not sure how you’ll need to borrow or when exactly you’ll need it. It gives you access to cash for a set period of time.
If you aren’t comfortable with the HELOC’s variable interest rate, you may prefer a home equity loan for stability and predictability of fixed payments.
Make sure you do not borrow more than you can afford to pay back.
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 to 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 type of home equity loan 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 that a fixed rate 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 variable rate home equity loan or 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...