How Remodeling With a Home Equity Loan Works
A home equity loan is secured by your home. In other words, your home serves as collateral for the loan. If you’re taking out a home equity loan, you’ll want to find the best lender and rates that you can. Your credit and home value will affect your interest rate and how much you can take out.
Shop for a Lender
First choose a lender for your home equity loan, also known as a second mortgage. You might consider the lender that holds the first mortgage, or primary mortgage, for your home. You also may want to ask relatives and friends for recommendations. When you’re looking at lenders, pay close attention to the terms of the loan, including the annual percentage rate (APR) each lender offers and any prepayment penalties it might charge if you pay off the loan early.
Check Your Credit
Before you decide on a lender, check your credit report and credit score. Doing this lets you spot issues or errors that could be dragging down your credit. For instance, maybe a credit card payment shows up on your credit report as being paid late when it actually was paid on time. In general, late payments and other negative information stay on your credit report for seven years. If a credit bureau determines your payment was incorrectly listed as having been late, the late payment is supposed to be removed from your credit report. Removal of the late payment might boost your credit score, which can lead to better loan terms.
Fill Out an Application
Once you’ve chosen a lender and checked your credit, you’re ready to submit an application for a home equity loan. These days, many lenders allow you to apply online. When you’re completing the application, you’ll be asked about the property you own, your income, your expenses, and other financial details that help lenders decide whether to approve your application. You’ll need to provide lenders with documents such as W-2 forms, pay stubs, a copy of a photo ID, and proof of home insurance. To qualify for a home equity loan, you’ll generally need:
A credit score that meets the lender’s requirements; the higher your credit score is, the more likely it is that you can secure a lower APR. At least 20% equity in your home, which is determined by what’s known as the loan-to-value ratio; home equity is the amount your home is worth minus the amount you still owe on your primary mortgage. A debt-to-income ratio that is 43% or less; this ratio is calculated by taking all of your monthly debt payments and dividing that number by your gross monthly income. Proof of your ability to make loan payments
The lender might also order a property evaluation and interior inspection of your home before approving your loan. If your application is approved and you close on the loan, the lender will typically give you a lump sum of money that it will ask you to pay off over a set period of time.
How Do You Repay a Home Equity Loan?
The term of a home equity loan usually ranges from five to 30 years. So, if you have a 30-year loan, you’ve got 30 years to pay it off. The loan’s APR and monthly payments are typically fixed. Keep in mind that if you’re unable to keep up with the monthly payments, you could lose your home. Since the loan has been secured by your home, the lender may foreclose on your home and assume ownership of it if you default on the loan.
Pros and Cons of Using a Home Equity Loan for a Remodel
Pros Explained
Fixed rate and payments: Generally, the APR and monthly payments for a home equity loan are fixed, which means they won’t change throughout the loan period. This might be a more predictable way to finance a home remodeling project than using a credit card or line of credit, because you know how much you’ll have to pay back each month.Upfront money: When you take out a home equity loan, you receive all of the borrowed money in one lump sum. That means you can cover your home improvement costs all at once, and gradually pay back the loan over time.Potential increase in home value: Depending on the type of home remodeling project, the value of your home could go up.Possible tax deduction: When you put money from a home equity loan toward a home remodeling project, you may be able to deduct the interest you pay on the loan. This could help offset the cost of the remodeling project.
Cons Explained
Higher interest rate: The APR for a home equity loan may be higher than it is for a home equity line of credit (HELOC). Therefore, you might be paying more interest in order to finance your home remodeling project. Closing costs: You will probably need to pay closing costs, and you may have to pay other fees as well. In general, closing costs are equal to 2% to 5% of the loan amount. These additions could drive up your home remodeling costs. Possible loss of home: If you fail to keep up with payments on a home equity loan, the lender might foreclose on the home and take ownership of it. If that happens, the home remodeling project wouldn’t have been worth it. Potential decline in home value: Over time, the value of your home may go down, which could mean you owe more on your first and second mortgages than the home is worth. In this case, a home remodeling project financed with a home equity loan would probably not provide a return on your investment.
Should You Use a Home Equity Loan To Remodel?
There’s no clear-cut answer when it comes to deciding whether you should use a home equity loan for a home remodeling project. However, there are some factors that can make your decision easier.
When You Should Use a Home Equity Loan to Remodel
Here’s when it might make sense to use a home equity loan for a remodeling project:
The remodeling project increases the value of your home: If you’re taking on a kitchen makeover, for instance, it might add more value than a bathroom addition would.The home equity loan won’t cause financial hardship: If you can afford the monthly loan payments, then a home equity loan could be a smart way to pay for a home remodeling project.The home equity loan would be a less costly financing method: If the overall interest for the project is less than, say, a credit card, a home equity loan might be better. If you add up the interest you’d pay on the loan versus a credit card and the amount would be lower for the loan, you might want to keep that credit card in your wallet.
When You Should Not Use a Home Equity Loan to Remodel
Here’s when it might not make sense to use a home equity loan for a remodeling project:
The home equity loan would put you in a financial bind and possibly cause you to lose your home: No home remodeling project is worth it if you have no home to live in.The remodeling project would add little if any value to your home: Some renovations have a better rate of return than others. A bathroom makeover, for instance, would likely deliver less of a return on your investment than a deck addition would.The project could be financed with money that’s set aside in a savings account: It may be better to avoid taking out a home equity loan if you already have the money. You won’t have to worry about missing payments in the future, and you can avoid paying interest.
Home Equity Loan vs. HELOC for Remodeling
You might prefer a line of credit rather than a one-time loan. In that case, a home equity line of credit (HELOC) might be a better fit for your needs than a home equity loan.
Interest Rate
The interest rate for a home equity loan is normally fixed, while the interest rate for a HELOC normally varies. So, a fixed interest rate may give you more peace of mind when it comes to financing a home remodeling project, but you could wind up benefiting from a lower HELOC interest rate down the road.
Monthly Payment
As you’re figuring out the cost of a home remodeling project, knowing that your monthly financing payment is fixed rather than variable might make it easier to budget.
