Should I Tap Into My Home's Equity For a House Reno? Here's What You Need to Know!
home equity loans, refinance with a home equity line of credit, home equity loans versus mortgage, we have got you covered on everything
“Can I borrow some money?”
So you're thinking about giving your home a little face lift but you don't have the cash on hand (or maybe you just want to learn the difference between a home equity loan versus a mortgage). Don't worry, you're not alone.
Many homeowners consider using their home's equity to fund a renovation project. But before you actually start demo day, let's take a closer look at what a home equity loan is and when it makes sense to use it.
As a primer, in this quick 5 minute read we are going to help you out down the path of home equity loans by discussing:
What a home equity loan is
Different types of home equity loans
What you will need to qualify for one
When it makes sense to use a home equity loan for a house reno
Risks involved
Alternatives to home equity loans
Let’s get started!
What is a Home Equity Loan?
Your home is likely one of your largest assets and as you pay off your mortgage, your equity in the property increases. As a quick example, let’s say you buy a house for $200,000. You put down 20% of the value (so $40,000) and you borrow the rest from a bank (borrow $160,000).
Your equity in the house to start is $40,000, but as time goes on and you pay down the $160,000 of debt that you owe the bank, your equity in the house increases.
A home equity loan is a type of loan that allows you to borrow against the equity you've built up in your home (so borrowing against that $40,000+ you have built up). It's like a second mortgage, giving you access to a lump sum of cash that you can use for whatever you like (including a house renovation, of course).
Types of Home Equity Loans
There are two main types of home equity loans: a home equity loan (HEL) and a home equity line of credit (HELOC). These are just fancy terms but all that really matters to remember is that they are two different ways to borrow money against your equity.
A HEL is a lump sum loan that provides you with the full amount of money you need in one go. It will usually come with a fixed interest rate and a set repayment schedule, making it easier to budget for your renovation costs. As time goes on, you pay interest on the loan and also pay it down until it is all gone.
Potential benefits of a HEL include: Predictable payment schedule allow you to plan, potentially lower borrowing costs vs. a credit card or unsecured personal loan, potential to be tax deductible, and a longer term period to pay it back (HEL’s typically are anywhere from 5 to 30 years).
A HELOC, on the other hand, is like a credit card for your home equity. You apply for the line of credit and once you are approved for a certain amount, you can use it as you need it. Typically, you will only have to pay interest on the amount you actually use and you'll be able to borrow more as needed (say for payment installments on a renovation).
Potential benefits of a HELOC include: more flexibility on draw and repayments, potentially a lower rate as they can come with lower rates than credit cards, potential to be tax deductible similar to a home equity loan, and typically fewer restrictions on how you use the funds.
How To Qualify For a Home Equity Loan
Regardless of which type of loan you choose, home equity loan requirements and HELOC requirements are the same most of the time. You will typically need:
A minimum percentage of equity in your home (usually you can only borrow up to 80 or 85% of your home’s total value including your mortgage-here is a handy calculator)
Good credit (here are some ways to improve your credit score)
Low debt-to-income (DTI) ratio (usually lenders don’t want your monthly debt payments higher than 40% of your monthly income before taxes)
Sufficient income
Reliable payment history
Does it Make Sense to Use a Home Equity Loan for a Home Reno?
Taking out a home equity loan or HELOC can be a wise decision if you need money to fund a home improvement project or consolidate high-interest debt. Since the loans are secured by your home, the interest rate is usually lower compared to unsecured loan products such as credit cards or personal loans.
For example, home equity loan rates range between 3 percent and 12 percent, depending on the lender, loan amount and the creditworthiness of the borrower, while the average credit card rates are heading to 20%.
When specifically looking at a home renovation, we would argue taking out a home equity loan or HELOC makes sense if you:
Have a clear plan for your renovation project: Before you borrow against your home's equity, make sure you have a clear plan for your renovation project. What do you want to achieve and how much will it cost? Having a detailed plan will help you avoid overspending and ensure that you borrow only what you need.
Want to add value to your home: A well-planned renovation project can add significant value to your home. This, in turn, can increase your home's equity and make it easier for you to borrow against your equity in the future. Be sure to also think about real estate trends in your area though (are people moving into the area over time? what is the outlook for the area longer term?).
Need a large sum of money: If you need a large sum of money for your renovation project, a home equity loan might be a better option than other types of loans. With a HEL, you'll receive the full amount of money you need in one go, which can make it easier to manage your renovation costs.
Have a good credit score: To get the best rates on a home equity loan, you'll need a good credit score. If your credit score is in good shape, you may be able to get a lower interest rate, which will make it easier for you to repay your loan.
What Are The Risks Involved?
While this section comes last, it is probably the most important. When you borrow money against your home, this puts your home on the line at the end of the day if you cannot repay the loan. As a result, any decision you make here should be approached with caution and a great level of planning.
As a way to plan, think about more negative scenarios for you and your family (i.e. potentially losing a job) and what your ability to pay back the loan would be even under even those conditions. Some of the main risks involved are:
Risk of foreclosure: As discussed above, if you can't keep up with your loan payments, you risk losing your home to foreclosure. This is a serious risk and one that you should consider carefully before taking out a home equity loan.
Interest rates can change: With a HELOC, your interest rate can change over time, making it more difficult for you to manage your loan payments. Make sure you understand how the interest rate on your loan works and how it could affect your payments in the future. As we noted in our newsletter last week, while current indications are that interest rates overall may be peaking soon, this is no reason to think that they will for sure.
Alternatives To Home Equity Loans
Although taking out a home equity loan can be a good financial decision, it’s not the best option for everyone. Here are some alternatives to consider:
Personal loans: A personal loan is a lump sum of money you receive from a lender; it comes with a fixed interest rate and fixed monthly payment. Terms usually last from one to seven years. Most personal loans carry a higher interest rate than a home equity loan because they are unsecured (i.e. if you don’t pay it back the lender has nothing whereas with a home equity loan the lender knows your house is backing the loan). A personal loan can be a better option if you can secure a lower interest rate or don’t want to risk losing your home with a home equity loan.
0 percent intro APR credit cards: When you use a 0% intro APR credit card, you can avoid paying interest on purchases during a promotional period that often lasts between 6 and 21 months. Using this option instead of a home equity loan can help you avoid interest charges altogether if you have a short-term home renovation project. Be careful here though, as once the promotional period ends typically rates will jump much higher. For some suggestions or more on this option check this link out.
CD loans: CD loans are secured by your certificate of deposit (CD) account if you have one. The lender typically charges you two to three percentage points above your current CD’s interest rate. This can be a better option if you’re looking to secure a lower interest rate than a home equity loan.
Family loans: Family loans are loans you get from family members. This can be a good option if a family member is willing to let you borrow money with no or low borrowing costs. However, keep in mind that not repaying the loan might harm your relationship with your relative.
Final Thoughts…
A home equity loan can be a good idea in many cases if you are doing something that adds value to your house like a renovation. Some solid planning and thinking is required though about how you are going to pay back the loan as well as really looking around at all of your options.
Whatever you decide to do, try to think about all of the scenarios at play and what you might do in each one. The future is always uncertain but if you plan for adverse events, this will leave you feeling much more prepared and ready to take on a loan.
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