Using afor remodeling projects is one of the smartest uses of your funds because there are additional benefits that are not an option when you use the loan for . A home equity loan is when you borrow against the equity you’ve built up in your house after making consistent mortgage payments over the years, and you receive that equity as cash that you pay back over a set period of time.
When you use ahome improvement loans, the interest is tax deductible while you add value to your home by increasing what the property is worth. So you get maximum financial benefit because you’ve reinvested the funds into an asset (your house) that will pay for itself when you sell it at a higher price down the line, as well as save yourself years of interest on payments.
Here are some of the key pros and cons to consider when using a home equity loan for a remodeling project, how to decide whether to use a home equity or(HELOC), as well as alternative ways to pay for housing projects if a home equity loan is not right for you.
Advantages of using home equity for remodeling
The main benefits of using home equity for remodeling are the ability to deduct your home loan interest from your taxes and enjoy the windfall from your home improvements when you sell your property later. Plus, you can enjoy living in your new and improved home until you sell it.
The interest is deductible
The interest on your home loan is tax deductible as long as you use the money to “buy, build or substantially improve your home,” according to the IRS. However, there are limits to how large a loan you can take out to qualify.
The interest rates are lower than other loans
Mortgages are lowcompared to other types of loans such as personal loans and credit cards. Current equity interest rates are just under 7%, but personal loans are at 10.7%, according to Bankrate, CNET’s sister site. But remember, the interest rate a lender offers you will always depend on personal financial factors such as and how much debt you carry, why it’s important to keep your debt and other living expenses low whenever possible.
You receive a lump sum at a fixed rate
With a home loan, your interest rate will be fixed, so you don’t have to worry about it rising in onelike who we are today. Your monthly payments will always be consistent and will never increase or decrease like they do with a HELOC.
Renovations increase the equity in your home
You replace and build more equity in your home. Even if you took cash out of your home for your loan, using the money to renovate means you’re increasing the value of your property and thus increasing your equity. But it does matter what type of renovation projects you embark on, as some home improvements offer a higher return on investment than others. For example, a minor kitchen remodel will recover 71% of its value when you sell a house, compared to 61% for a deck addition, according to a 2022 report from Remodeling magazine that analyzes the cost of remodeling projects.
Disadvantages of using home equity for remodeling
Although there are advantages to home loans, there are alsofor home repairs. If property values fall when or other disruptive financial events occur, the improvements will not end up increasing your home’s value as you had planned because your home will have decreased in value overall.
You could lose your home
Your home secures the loan. If you miss payments or for some reason can’t repay your loan in full, you could lose your house to your lender or financial institution, who will use the proceeds from the sale to pay back what you couldn’t.
Loan limits for interest deduction
Your loan interest is only tax deductible up to $750,000 for joint filers or up to $375,000 for single filers.
Some projects are a better use of the funds than others
If you do not plan to sell your home in the future, it may not make sense to use the funds for improvements. Some renovation projects don’t add as much value as others. For example, putting in new windows has an ROI of just 66%, but installing a new garage door has a 93% ROI when selling your house, according to the Remodeling magazine report.
Home values may fall
Whileover the past two years, if for some reason home prices fall in your area, your investment in improvements will not have actually increased your home’s value. When you end up owing more on your mortgage than what your home is actually worth, it’s called negative equity or being “underwater” on your mortgage.
Property loan vs. HELOC: Pros and Cons
HELOCs are similar to home equity loans in that you can deduct the interest on both types of loans from your taxes, but there are a few key differences. ONEwith your loan, such as if you need to continually withdraw funds for a recurring expense such as college tuition, or don’t know the exact amount of funds you need for an ongoing project such as home renovations. Here’s a rundown of the pros and cons of using either a home equity loan or a HELOC for home improvement projects.
Using a home loan for home improvements
- Your interest rate is fixed: With a fixed rate, you don’t have to worry about your payments going up or paying more in interest over time. Your monthly payment will always be the same, regardless of what happens in the economy.
- You receive a lump sum: You receive all the money in advance in one payment, so you have access to all your money immediately.
- You must use all the funds: With a HELOC, if you don’t end up needing your total credit limit, you’re not obligated to use it all. But with a payday loan, you receive all the money at once, regardless of whether you need it or not. That means you’ll also have to make payments on the total loan amount from the beginning of the loan term, which will likely be higher than the interest-free payments you can make over the decade-long drawing period of a HELOC.
- Your interest rate remains fixed when rates fall: If the interest rate drops for some reason, you are stuck with your interest rate and cannot change it.
Using a HELOC for home improvements
- You have a revolving credit limit: A HELOC works more like a credit card that you access when you need money, giving you more flexibility than a home equity loan.
- You can only pay interest: You can make interest-free payments during the draw period of your HELOC, the set period in which you can draw money from your line of credit (usually a 10-year term), meaning you can borrow a large amount for a longer period of time, while you only make minimum payments per month.
- You can convert a HELOC to a home loan: If interest rates start to rise, you have the option of converting your HELOC to a fixed-rate HELOC or home equity loan to help save money. (You cannot change your interest rate with a home loan.)
- Variable interest rates can be too much: Your monthly HELOC payment will go up and down depending on current interest rate trends, so your budget should be flexible enough to allow for the possibility of higher payments at any time.
- Monthly payments increase after the drawing period: After your draw period is over, you’ll have to pay both interest and principal on your loan, meaning your monthly payment will increase significantly when your repayment period begins. A typical HELOC repayment period is 20 years.
- Your home can be taken over: Your home secures the loan. Just like a home loan, you must put up your house as collateral to secure the loan so that your bank or lender can take over your property if you fail to make your payments.
Alternatives to using your home equity for home improvements
If using a home loan for remodeling does not make sense for your particular situation, there are alternative financing options to consider. As with all forms of credit, make sure you can responsibly manage the amount you borrow. As a best financial practice, you must never use a home loan – or any other form of financing – for expenses other than the original purpose of the loan.
Payout refinancing: ONEis a good option for homeowners who want to lock in a lower interest rate on their mortgage. ONE just like a home loan, but it replaces your current mortgage, so you only have to make one monthly payment, while saving money on interest over the life of your mortgage. However, the interest rates must typically be lower than your mortgage for this option to make sense.
Personal loans and credit cards:and tend to have higher interest rates than home equity loans or HELOCs, but you don’t have to put up your house as collateral to secure the funds.
Home equity loans can be a cost-effective way to borrow against your home’s equity when it comes to remodeling because they are tax-deductible and provide the means to increase the value of your home. But before you decide how to finance your next home improvement project, consider the pros and cons of a home equity loan and a HELOC to determine which one best suits your needs.