Using Home Equity to Finance Home Improvements

Home improvements can take many different forms: from major projects like building an addition to smaller ones like a few new appliances or a new coat of paint. Many times people turn to home equity products like home equity loans or home equity lines of credit to finance their home projects. This is usually a smart financial move as home equity products typically carry a lower interest rate because they are secured by the value of your home.

What type of loan is best for home improvements?

You may have smaller projects for which you don’t want to tap into your home’s equity. For example, if the only project you want to tackle is refacing your kitchen cabinets, a Personal Loan may be a better option. But for many home improvements or renovation projects, the cost will surpass what you may be able to fund via a personal loan. Rather than turn to higher interest rate credit cards, your home’s equity could provide you with the financing you need.

Is a Home Equity Loan or a HELOC a better option to fund home improvements?

Both a Home Equity Loan and a Home Equity Line of Credit (HELOC) are good solutions for home improvement projects for several reasons. Both options use your home as collateral. This means your interest rate will likely be lower than with a personal loan or credit card, which are both forms of unsecured credit. Because home improvements can be costly, you will definitely want to find the best rate possible to save on interest charges.

Determining which is a better option, though, depends on your individual needs. There are pros and cons to both so it’s important to understand what your home improvement plan is before deciding how to fund it. Will you be doing several projects over a length of time? Or are you focusing on a single larger project?

If you are planning several projects over a length of time, a HELOC may be a better option for you. Because HELOCs allow you to draw money as needed, you can access your line as your home improvement projects happen. You only have payments if you use your HELOC, and often those payments are interest-only during the draw period. You can also access your line in the event of an emergency, although it’s important to resist the temptation to use it for miscellaneous expenses outside of your home renovation projects.

Draw Period

The draw period on a Home Equity Line of Credit is the time frame during which you can access funds. During the draw period, you will not need to make any payments unless you actually access your line, and often those are interest payments only.

Once the draw period is done you will no longer be able to take advances against your HELOC and you will begin the repayment period.

A Home Equity Loan might be a more attractive option if you have a single large project you are going to work on such as an addition to your home. With this option you will receive all your funds upfront, allowing you to pay for architects, contractors, furnishings, and anything else that goes into a large home improvement project. Before applying for a Home Equity Loan be sure to calculate all the expenses that will be associated with your project and build in extra for unexpected costs. Keep in mind with a Home Equity Loan you’ll receive all the funds as a lump sum, so you may want to set up a separate savings account to keep the money separate and earmarked solely for your project.

Is a HELOC better than a credit card for home improvements? 

While some homeowners opt to charge home improvements expenses to their credit cards, HELOCs are an attractive alternative. They allow you to access funds periodically, just like a credit card, but without the high-interest rate. Unless you are using a card with a special zero percent or other low introductory rates, putting a large charge on your credit will add up over time thanks to higher interest. If you do decide to use a card with an introductory rate, your goal should be to pay the balance before that introductory rate expires. If you aren’t confident that you’ll be able to do so, or if you think you could end up adding additional charges to the card, you may want to consider a HELOC instead.

How much can I borrow for home improvements?

The maximum amount you can borrow with a home improvement loan depends on the loan to value (LTV) guidelines at your financial institution. At most lenders, you can borrow up to 80% of your home’s value. LTV simply states the maximum percentage of your home’s value that your financial institution will allow you to borrow and is designated to protect you and the lender in the event your home value decreases.

For example, if your house is appraised at $400,000 then the maximum loan would be $320,000. If you have a current mortgage with a balance of $200,000 then, depending on credit and income, you could potentially borrow $120,000. When you’re calculating how much you need to borrow, you’ll want to shop around to get several quotes from reputable contractors and build a budget that you’ll stick to. It’s important to adjust your budget to be sure you can afford the cost of your home improvement projects. A budget will allow you to see all of your income versus all your expenses, and allow you to adjust where you may be spending your money. Keep in mind you don’t want to decrease your savings in order to pay for a Home Equity Loan or Line of Credit. Instead, look for opportunities where you can comfortably cut back on spending, and determine if your estimated monthly payments will be feasible.

Do I qualify for a Home Equity Loan or Line of Credit?

Lenders will often look, at the very least, at your credit score and your debt to income ratio (DTI) before deciding to lend to you. Your credit score is a mathematical analysis of how likely you are to repay your loan on time. Your score factors in things like how many loans or credit cards you have, how well you pay your bills on time, how much of your available credit you’ve used, and how old your oldest credit or loan account is. All these factors are weighed and combined to assign you a score. It is very important to have a good understanding of what your credit score is before you begin the process of applying for a Home Equity or Line of Credit loan. If it’s been years since your initial mortgage, you don’t want any surprises. If your score isn’t high enough you can take steps to improve it.

DTI measures how much debt you currently have relative to your income. A DTI that is too high suggests you may be spread too financially thin to be able to make the payments on your Home Equity or Line of Credit loan. Even if you have a good credit score a high DTI can cause some lenders to deny your application. Using a monthly budget tool is a great way to manage your finances and keep your debt at a manageable level.

How can I save money on home improvements?

There are ways to make sure you’re making the most of your home improvement loan and saving money on your projects. Taking the time to thoroughly plan and research your home improvement project is the single most important step you can take. Doing so will help you feel more prepared and will ensure the project goes as smoothly as possible. Here are some additional tips:

1. Build a strict budget and stick to it. – It will be easy to be tempted by extras and high-end materials. Sticking to your budget will be important to keep you on the right financial path.

2. Plan for the unexpected. – Make sure your project budget includes about 20% of the total cost for unexpected expenses. It’s far better to build these costs in and be prepared for them than to have to come up with additional funds after your project has started.

3. Think Timing. – Consider doing renovations during “off seasons” when contractors are less busy. This may save you some money.

4.  Shop Around. – It’s important to get at least 3 quotes from reputable, insured contractors. This will help you determine whether you can afford the project and ensure you’re getting a good deal.

5. Pick your project wisely. – Which will add the most value to your home? Which can you afford? Which requires the lowest amounts of long-term maintenance costs?

With several options and lower rates, a Home Equity Loan or Line of Credit can put the goals you have for your home within reach.

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