Big expenses come at us throughout our lives, sometimes unexpectedly, sometimes planned. Regardless of the circumstance, you’ll need a way to finance these major purchases when they arise. If you own a home, your best course of action may be to do so with a home equity loan.
Home equity loans allow you to use your house as collateral and you can use the money for anything you like. Many people take out home equity loans to finance renovation projects that make their property more valuable.
What are home equity loans?
A home equity loan, also commonly known as a second mortgage, is a type of loan in which homeowners borrow money against the equity they own in their house. Home equity is calculated by taking the current value of your residence and subtracting your outstanding mortgage balance. For example, if your house is currently estimated to be worth $500,000 and you still owe $100,000 on your mortgage, then you have $400,000 in home equity. Your loan will be borrowed against this total. Typically, most lenders will allow you to borrower up to 80% of the value of your property minus the first mortgage balance.
Home equity loans usually come with fixed rates. This makes them attractive options when interest rates are low. In fact, these rates are often lower than credit cards and personal loans. This means that home equity loans will be less expensive over the lifetime of the loan than financing your large expense via credit cards or other loan types. You may also be able to deduct the home equity loan interest payments from your taxes. AAA recommends consulting a tax advisor for personal tax guidance.
Home equity loans aren’t without their risks, however. If you are unable to pay the loan back, the lender could choose to foreclose on your house. Therefore, you’ll want to be on sound financial footing before taking out a home equity loan.
How do home equity loans work?
Your home equity loan will be paid out in a single lump sum. This comes with its own pros and cons. On the bright side, you’ll have access to all the funds you need right away. But, since you’re not borrowing money as you need it, you’ll have to have a very good estimate of how much money you need to borrow from the start. If your home renovation project costs less than the amount borrowed, you’ll still need to repay the entirety of the loan. Speaking of which, home equity loans require borrowers to begin paying the loan back in monthly installments right away.
If you’re unsure of how much money you will need, you may want to consider a home equity line of credit (HELOC). Just like a home equity loan, a HELOC allows you to borrow against the equity in your home. But instead of receiving all the funds upfront, you can withdraw money as you need it. HELOCs function much like a credit card in that once you reach your credit cap, your balance will need to be repaid before you can withdraw more money.
What can home equity loans be used for?
Home equity loans do not need to be used on your home. In fact, the money can be spent on any big expense you need help financing, such as a wedding or business startup. One popular use for them is paying off credit card debt. Credit card interest rates are notoriously high. Paying off your credit card debt with funds from a low-rate home equity loan could save you a significant amount of money in the long term. It will also help consolidate your debt if you owe money on more than one credit card by allowing you to make just one payment every month.
Although funds from a home equity loan can be used for anything, it’s important to note that interest from these loans is only tax deductible if the funds are used on a home renovation project. Consult a tax advisor to see if your project is eligible.
There’s another convincing argument for using the loan on your home: it is a great return on investment. If you use the funds to add an extra bedroom, remodel the kitchen or install a pool in the backyard, you’re increasing the value of your property, which you will own entirely once your mortgage is paid off.
Renovations Worth the Money
So, which home equity loan renovations should you consider if you’d like to increase the value of your home? According to the National Association of Realtors’ 2022 Remodeling Impact Report, these interior projects provided the best bang for their buck:
- Hardwood flooring refinishing – 147% of project cost recovered at house resale
- New wood flooring – 118%
- Insulation upgrade – 100%
- Basement conversion to living area – 86%
- Closet renovation upgrade – 83%
And these were the most financially beneficial exterior projects:
- Roofing – 100% of project cost recovered
- Garage door – 100%
- Fiber cement siding – 86%
- Vinyl siding – 82%
- Vinyl windows – 67%