If you’ve had a mortgage on your home for some time, you’ve probably built equity. The same applies if you don’t have debt tied to your property or if market conditions have significantly improved, leading to an increase in your home’s value.
In a nutshell, equity is the difference between your home’s value and any debts against it. Home equity can be a great funding solution if you want to renovate or remodel your property but haven’t saved enough cash.
However, before tapping into your home equity for remodeling or a home improvement project, it’s a good idea to understand the best way to use this financing option, along with the pros and cons.
Understanding What Home Equity Is
Before leveraging your home’s value to fund renovations, it’s essential to grasp what home equity is. Simply put, it’s the portion of your property that you own outright.
How Does Home Equity Build Up
Over time, as you make mortgage payments, you gradually increase the equity in your home. Here’s a closer look at how it builds up:
- Principal Payments: With each mortgage payment, a portion goes towards reducing the balance of your loan, which increases your equity. As you continue to pay down your mortgage, the equity accumulates because you owe less on the home’s total value. This process is a reliable method to build wealth, as over time, the portion of the payment towards the principal increases while the interest portion decreases, known as amortization.
- Property Value Appreciation: If your home’s market value rises, the equity you hold also goes up, even without any effort on your part. This can occur due to changes in the market, improvements in the community or upgrades to your home. It’s a less predictable but potentially lucrative source of equity growth. Although you can’t control the market and how it’ll perform over time, maintaining and improving your property can help maximize its value.
Factors Affecting Home Equity
Various factors can impact the equity you have in your home, such as:
- Market Fluctuations: As mentioned above, the real estate market can affect your home’s value and, consequently, your equity. If the market experiences a downturn, property values may decrease, which can reduce the amount of equity you have. On the other hand, in a booming market, your home’s value and equity could rise significantly without any additional investment from you.
- Additional Liens or Mortgages: Any additional debts secured by your home, like a second mortgage, reduce the equity available to you. These debts are subtracted from the current market value of your home to determine the actual amount of equity you have. So, it’s vital to consider the impact of taking out these loan products and how they can affect your overall equity position.
- Repayment Period: The length of your mortgage repayment period can also influence how quickly you build equity. A shorter loan term means faster equity growth because more of your payment goes toward the principal balance each month. However, this also means higher monthly payments, which may not be feasible for all homeowners.
- HELOCs: Taking out a home equity line of Credit (HELOC) can affect your equity. A HELOC might have variable interest rates, meaning payments can fluctuate based on market conditions. So, the amount of principal repaid with each payment may also follow suit, potentially impacting the amount of equity you build over time.
- Loan Payments: Making larger or additional payments towards the loan principal can help build home equity more rapidly. You can decrease the loan balance faster and increase your home equity by paying more than the required monthly payment. This is an effective strategy for homeowners with wiggle room in their budgets and who wish to invest in their property’s equity.
Be aware that home equity may not always trend upward. Depending on your financial decisions and external economic conditions, it can fluctuate as time progresses.
Can You Use Home Equity for Renovations?
Yes, you can use home equity to fund renovations. It’s most often withdrawn by homeowners through a home equity loan or a home equity line of credit (HELOC).
Home Equity Loan
A home equity loan gives you a lump sum, making it ideal for renovations with a defined budget. With fixed interest rates, you’ll have predictable monthly payments.
This type of loan is beneficial for large-scale projects like kitchen overhauls or adding an extension to your home, where the total expense is known upfront. Since the loan is secured by your home, interest rates are typically lower than unsecured loans, making it a cost-effective option. Still, it’s essential to budget carefully, as borrowing more than needed can lead to unnecessary debt. And even worse, defaulting on the loan could put your home at risk of foreclosure.
Home Equity Line of Credit
Alternatively, a HELOC functions similarly to a credit card, allowing you to draw funds as needed during the draw period. It’s generally between 5 and 15 years. This option is flexible and can be suitable if project costs are uncertain.
HELOCs are particularly useful for ongoing projects or renovations that are done in stages, where you may not need the entire sum at once. During the draw period, you can borrow up to your limit, pay it back and borrow again. Keep in mind that HELOCs usually have variable interest rates, which means your payments could increase if market conditions change and rates rise.
Best Ways You Can Use Your Home Equity for Renovation
Many homeowners use their home’s equity for various reasons. So whether you want to remodel your kitchen, bathroom, or patio, here are the best ways to use your home equity for your next renovation project.
Value-added Home Renovations
One of the obvious reasons homeowners do renovation or remodeling projects is to add value to their homes. Not all renovation projects, though, add to a home’s value. Some major renovation projects, such as adding a second story, extra rooms, and building a patio/deck, are known to increase a property’s value.
Capital Improvements
Capital improvements are permanent home renovations or additions that increase the property’s value, extend the property’s life, or change its use. Examples of capital improvements include installing kitchen cabinets, a water heater, and building a deck. Your home’s equity can help you make capital improvements on your property.
Energy-saving Improvements
Another great way to tap into your home equity is by doing energy-efficient upgrades. This can include installing energy-efficient lighting, hot water heaters, appliances, programmable thermostats, and even adding insulation. Not only do energy-saving improvements lower energy bills and improve comfort, but they also increase a home’s value.
Renovations for Medical Needs
Home renovations for medical needs, such as expanding the doorways, installing railings and support bars, lowering kitchen cabinets, and other qualifying home modifications, are fully deductible. However, some medical renovations, such as installing an elevator so that a disabled person doesn’t have to use the stairs, can increase the value of your home. Since medical renovations are expensive, using your home equity to finance such undertakings makes sense.
Other Tax-deductible Home Improvements
Home improvements are generally not tax deductible for personal residences. However, you may qualify for a tax credit if you install energy-efficient equipment, such as solar panels and geothermal heat pumps, or upgrade to energy-saving windows. In addition, medical renovations are also tax deductible.
Other home renovation projects that may qualify for the tax credit include home office improvements, capital improvements, and repairs for federally approved disasters.
What are the Benefits of Using Home Equity to Renovate?
Using your home equity to renovate your property has several advantages, including:
Low-Interest Rates
Because home equity loans are secured by the property you borrow against, they tend to have interest rates that are lower than unsecured loans like personal loans and credit cards. In addition, a home equity loan has a fixed interest rate, meaning you’ll make fixed monthly installments over the life of the loan.
Return on Your Investment
Tapping into the equity in your home to get the funds you need for your home renovation project is a great way to get your return on your investment. Whether you’re renovating your basement, attic, or garage door, most home improvement projects increase a home’s value. However, it’s important to note that ROI is only realized when you sell your home.
Avail of Tax Deductions
Another potential benefit of using your home equity for renovation is the tax write-off. The interest paid on home equity loans and home equity lines of credit (HELOC) may be tax deductible up to a certain amount if you use the funds to substantially improve the home that secures the loan.
What About the Drawbacks of Using Home Equity to Renovate?
While using home equity to renovate comes with benefits, going this route has drawbacks, too.
Your Home May be Used as Collateral
One of the major disadvantages of taking out a home equity loan is that you risk losing your home if your financial situation changes down the road. If you fall behind on your monthly payments or, in the worst-case scenario, default, your house may face foreclosure.
Therefore, before taking the plunge by signing a home equity loan agreement, it’s wise to evaluate your current and future financial situation. This includes your current debt level, employment situation, and other factors affecting your ability to make on-time loan payments.
Possibility of Loan Recall by the Bank/Lender
A home’s value changes with the market. During a market downturn, for example, it can cause the value of your home to fall below the amount you still owe. If this happens, the bank or your lender may recall the loan and force you to pay off the remaining loan balance immediately. Failure to do so could lead to foreclosure.
With that in mind, it’s always a good idea to never borrow more than what you need for your home renovations to avoid a loan recall. Plus, ensure that the renovation you plan to do will boost your home’s value.
It Might be More Than What You Need
Lenders typically have minimum borrowing requirements for home equity loans, meaning you may have to borrow more than what you need, especially if your renovation project is minor. However, using your home equity to renovate your property might make sense if you plan to do major renovations, such as a room addition or building a second story.
If you have smaller projects like refreshing your rooms with new paint, giving your kitchen cabinets a new look, or installing new lighting fixtures, it may not be a good move to take out a loan with huge minimum borrowing requirements. Instead, consider alternatives like personal loans, cash-out refinance, or credit cards for such projects that will save you money.
There are Additional Costs
In most cases, using home equity to secure a loan for home renovation projects comes with extra costs. Since a home equity loan is considered a second mortgage, you’ll need to pay closing costs ranging from 3% to 6% of the total renovation project and other fees. This includes appraisal fees, origination fees, credit report fees, and other additional costs. Therefore, it’s crucial to consider such costs when deciding if using home equity to renovate is the right choice for you.
The Bottom Line
Home equity can be a valuable resource if you want to renovate your home. Still, it’s not without risks that should be evaluated before moving forward. Be sure to evaluate home equity products from several lenders and compare your options.
Most importantly, consult with a financial advisor to decide the best way to finance your renovation project using home equity. Each option has its benefits and drawbacks, and it’s vital to match your financial situation with the right choice. Remember, equipping yourself with the proper knowledge gives you the confidence to make an informed decision. Plus, it helps ensure that your investment in your home contributes to its value without adding unnecessary stress or damaging your financial health.
If you’re considering renovating your home and want to leverage the equity you’ve built, using a Cash-out Refinance can be an effective strategy. By tapping into the value of your home, you can access funds to fund your renovation project. Remember, using your home equity to renovate can be a smart financial move, but it’s essential to carefully consider your options and choose the right financing solution for your needs.
