Home equity and home improvement: 10 questions to ask.
For homeowners across the nation, buying a home represents more than just a roof over their heads – it’s an investment. Since most of us can’t afford to buy a home outright, we borrow in order to buy, and the amount we actually own (also known as equity) generally grows with each mortgage payment. Ultimately, that equity is the difference between what a home is worth and what the borrower owes on it. Some people sit on their equity, content to watch it grow and save it for retirement or a rainy day. Others, however, put that equity to use on home improvement projects, ideally boosting the value of their home further.
So what if you do want to use some of that equity? Refinancing your mortgage is one option. There, you’re essentially closing out your old mortgage and opening a brand new one, which can allow you to take some cash out. However, refinancing may make less sense given that current interest rates are increasing after historic lows.
Home equity loans, home equity lines of credit and hybrid products (collectively referred to herein as “home equity products”) are an alternative worth considering. Originally designed to help fund home improvement projects – from repairs and renovations to new additions – these products, when compared to personal loans, generally carry lower average interest rates and longer loan terms, making them well-suited to these needs.
Building Home Equity
The hope for any homeowner is that, as they make their monthly payments and their mortgage balance continues to decrease, the value of their property either remains the same or increases, thus increasing the homeowner’s equity over time. Once the homeowner amasses enough equity, they can tap into it with a home equity product.
Millions of homeowners utilize out some form of home equity product (10 million homeowners are expected to take out a HELOC between 2018 and 2022) and flexibility is often the reason why.
If you’re one of the millions of homeowners thinking of tapping into your home equity to make home improvements, here are some questions you should consider first.
1. Do you have a healthy cushion of equity in your home?
Typically, lenders require borrowers to own at least 20 percent of their home (e.g., have 20 percent equity) in order to qualify for a home equity product. Additionally, most lenders also will limit the percentage of debt (including the new loan.) It’s important to remember that if you take a significant amount of equity out of your home and then experience a dip in the housing market, you could owe more on your home than it’s worth. It’s always a good idea to talk to a financial planner before making big financial decisions like this.
2. How much would you like to borrow?
If you’re sitting on a considerable amount of home equity, you may be tempted to use as much of it as possible. A wiser choice might be to use what you really need, while accounting for unexpected expenses. There’s also a big difference between unavoidable and elective home improvements. Leaking roofs and busted water pipes often require immediate attention, leaving the homeowner with few options when it comes to how much they choose to spend. Others may have a long list of “wants” and in order to get the most out of their home equity loan, they may want to prioritize the work based on which goals are most important.
Finally, when prioritizing home improvements, homeowners who plan to put their home on the market in the near future may want to consider projects that add to the market value. Window replacements, new siding, heating and air conditioning upgrades could all increase a home’s value, though it is best to speak to one or two local realtors who really know the market before deciding how to spend your equity.
3. How much time would you like to have to repay the loan?
Your loan’s term is the amount of time you have to repay what you’ve borrowed. A shorter term typically means higher payments but a lower total amount of interest over the life of the loan. A longer term lets you spread the payments out, lowering the actual amount due. However, all else equal, you’ll ultimately pay a higher total amount in interest. The optimal solution should be driven by your specific needs.
4. Do you prefer a fixed rate or a variable rate loan?
Interest rates are another important consideration when it comes to tapping into your home equity. More often, home equity loans have a fixed interest rate, while HELOCs have a variable or adjustable interest rate.
As the name suggests, fixed interest rates do not change over time, whereas a variable interest rate may change over time. The variable rate associated with a home equity product is typically based on the current prime interest rate or LIBOR, which fluctuates. Variable interest rates are usually initially lower than fixed interest rates, but there is a risk that they will climb higher over time.
5. What fees are associated with home equity products?
For homeowners, the notion of closing costs and fees is not new, but some fail to realize that home equity products may also carry a range of fees and costs. Depending on your lender and the lending opportunity, you may need to factor in the cost of an appraisal as well as origination fees, title fees, closing costs, and annual maintenance fees. Some lenders may even charge fees for paying the loan off early.
6. What’s your credit history?
There are a variety of factors that a lender will consider when determining if an applicant is eligible for a home equity product, and your personal credit is an important piece of the puzzle. Lenders will look both at your credit scores and one or more of your credit reports. The average person actually has dozens of credit scores as well as three credit reports from the three main credit bureaus, Experian, Equifax and Transunion. Credit reports and scores essentially tell lenders if you’ve had a good history of paying your debts and bills on time. Generally, the lower your credit score, the higher your interest rates are going to be. If your credit score is too low, you may not qualify for a loan at all.
In addition, lenders will look at your income, your debt-to-income ratio (i.e., how your income compares to your outstanding debt), and potentially your employment status.
7. What is the average home equity product interest rate?
For many homeowners, home equity products are a more affordable option because interest rates and APRs are typically lower than those attached to personal loans and credit cards. (Note that although they are typically similar, there’s a difference between APRs and interest rates. APRs reflect the interest rate plus other charges and are therefore usually higher than the interest rate.) In fact, while the average credit card APR hovers just over 16.8 percent, current average home equity product rates are under 6 percent.
A home equity product is secured debt, meaning that the debt is backed by an asset (in this case, the home). This is an important distinction because in the case of a secured debt the lender may have a right to the asset should the borrower stop making payments. As such, home equity borrowers must be conscious of their budget when determining how much to take out for home improvements and repairs.
8. How quickly do you need the cash?
The nature of your renovation project will often determine how quickly you need the loan. If a broken water pipe has flooded your basement, you likely needed the money yesterday. On the other hand, if you’re taking your time to design a new kitchen or bathroom, you may have more time to play with. Regardless of how pressing the need, it’s important to remember that traditional home equity products can take several weeks or even months to close, though some newer lenders have cut that time down to just a week or two.
9. Do you want a line of credit feature?
If you take out a home equity loan that comes with a line of credit feature, you will have the option to borrow money in addition to the original lump sum – though you may have to pay down a portion of that lump sum first in order tap into the line of credit.
Payments will ultimately be based on the amount used, and can fluctuate from month to month. Keep in mind that if you do draw from your line of credit, you will also be responsible for making payments on whatever is outstanding on the original lump sum, though the payments may be bundled into one.
10. Are you able to deduct the interest on your taxes?
When the Tax Cuts and Jobs Act of 2017 was enacted, many homeowners feared that they would lose the ability to deduct interest paid on their home equity product. And while there are many circumstances in which that is true, according to the IRS, home equity funds used to “buy, build, or substantially improve a taxpayer’s home” may still be eligible for deductions.
While many borrowers may be able to deduct the interest paid on their home equity products, the rules and stipulations for doing this have changed and are contingent on a variety of factors, including when you took out the loan or line of credit and the total amount of your equity loan and mortgage. To better understand the full tax implications of taking out a home equity product, you should consult a tax advisor regarding the deductibility of interest and charges.
Making home improvements and repairs can be costly, but if you have enough equity in your home, a home equity product can provide access to the cash you need to make a much needed repair or finish those improvements you’ve been dreaming about. You may find that your home improvement project is not only affordable but can add to the overall value of your home. Ask the right questions and find out how you can put your equity to work for you.