In 2018, John Sewell and his wife installed floor-to-ceiling windows and built larger living space on their 1950s ranch in Jackson, Mississippi. This year they’ve painted a new driveway, landscaping, front door, porch, and even the house – all thanks to a line of credit that is backed by the equity in the house.
And while the Sewells have not had their home appraised since purchasing it in 2009, they are confident that these home improvements will add to its value. Once they’re ready to sell, they’ll likely have recovered their investment, and more.
They could afford the renovation because they had equity on their home, which meant they owed less mortgage than the property was worth.
Home equity is calculated by subtracting the outstanding amount of your mortgage from the current value of your home. On the other hand, if you have equity in your home, you can borrow and use the house itself as collateral.
You can apply for either a home equity loan or a home equity line of credit, also called a HELOC. The Sewells opted for the latter and were able to get a HELOC of $ 50,000 with an interest rate of 4%.
A home equity loan is a lump sum, while a HELOC is a predetermined line of credit that can be drawn on over a period of time. You can apply to both banks, credit unions, and even online lenders. A good starting point for the search is the mortgage lender for your house, who can offer you particularly favorable terms.
While you can use a home loan and HELOC for similar goals or expenses, they have different functions and can be useful for different types of projects.
Since they are revolving lines of credit that stay open for up to 25 years, HELOCs are great choices for ongoing renovations, like the Sewells did. In that sense, they’re like a credit card, but with far lower interest rates because they’re backed by a tangible asset – your home that the lender can repossess if the borrower defaults – while credit cards are unsecured and therefore riskier for a lender are.
Both home equity loans and HELOCs are also useful for paying off higher interest debt or dealing with high expenses, but when used for home renovations they can add value to your home.
In general, the more equity you have in your home, the more money you can borrow, usually up to 85%. This amount is determined by factors such as your income and creditworthiness, as well as the value of the property.
This is when you should consider tapping into your home equity – and when not.
“Getting a relatively low-interest loan, especially if it is meant to cover the cost of a major home improvement or renovation, could be a smart financial move,” said Elliot Pepper, CPA, a co-founder of Northbrook Financial.
The interest on both types of home equity products is tax deductible if the funds are used for home improvements. The IRS is pretty specific about what the definition of home improvement supplies here is; Home extensions, a new roof, and replacing your HVAC are some great examples, says Lindsay Martinez, Certified Financial Planner at Xennial Planning.
Either way, home loan borrowing is a smarter way to finance a home improvement than using a personal loan.
Home loans and lines of credit can also be used to cover emergencies, especially in today’s tough financial environment. “A lot of people are very stressed from a liquidity perspective and their only real option might be to get a fixed rate home equity loan,” said Michael Caligiuri, CFP, Founder and CEO of Caligiuri Financial.
However, that should be the last option. When you have the financial headroom, your focus should be on building an emergency fund to handle exactly these types of events.
It can also be a good idea to use the money on a home equity loan or line of credit to pay off debts at higher interest rates. Some examples of high interest debt are auto loans and credit card debt. The annual percentage of credit card debt can be more than 20%, while home equity borrowing is far cheaper – up to 3% for high credit borrowers as the Federal Reserve keeps interest rates low to stimulate the economy.
When to Not Use Home Equity
Experts say you shouldn’t use a home loan for personal expenses such as “buying a boat, a fancy car, or paying for a wedding,” Martinez says. “You don’t want to put your home at risk if you default on payments,” she adds.
You should also be careful about tapping home equity if you don’t have an emergency fund or can’t expect a steady income.
It is important to remember that you are using your home as collateral and if you are late with your payments the lender can claim your home. You want to be confident in your overall financial health without biting off more than you can chew.
Especially as the economy continues to be hampered by the pandemic, this is a time to focus on building your emergency fund and retirement plan, and investing in things that are likely to bring a return, such as home improvement. Borrowing against home ownership can be a smart way to do this.