Should You Use a Home Equity Loan for Home Improvements?

Key takeaways

• A home equity loan provides a lump-sum payment in proportion to the equity you’ve established in your home; that equity serves as collateral. You repay the loan in monthly installments with interest, usually at a fixed rate.

• Home renovations can provide several benefits: (1) they may increase your home’s value, (2) they can make your home more comfortable, and (3) they can help you better suit your home to fit your needs.

• When you use a home equity loan to substantially improve a primary residence (i.e., add value, prolong the useful life or adapt for different use), the IRS may allow you to deduct interest payments on your taxes.

You’d like to freshen your home. How to pay for it?

Home renovations may increase your home’s value and possibly make it more attractive to buyers. If you’re not planning on selling, renovations can make your home more livable and suited to your needs.

If you’re ready to get started, you may be able to use a home equity loan for home improvements.

What is a home equity loan?

A home equity loan works like a traditional mortgage. You receive a lump-sum payment in exchange for using your home as collateral.

Unlike a traditional mortgage, a home equity loan provides funds in proportion to the equity you’ve established in the home. The equity is the amount of your home’s mortgage you’ve already paid off subtracted from your home’s current market value.

Other considerations include:

• Usually has a fixed interest rate

• Monthly payments begin immediately

• Closing costs and fees are similar to those of a primary mortgage

A major benefit of using a home equity loan is that the interest paid may be tax-deductible. This occurs when you use the funds to substantially improve the home. A “substantial improvement” is a renovation or improvement that

• adds value to the home
• prolongs its useful life or
• adapts it for a new or different use.

Another benefit is the typically low interest rate. Because the loan uses the home as collateral, banks may be more willing to lend money at good rates. Homeowners with the most competitive credit scores will usually secure the lowest rates.

Finally, you may gain a return on investment by improving your home with a home equity loan. This depends on many factors, such as the improvements you make, your location and the market. For example, updating your kitchen or adding a home office could add value for future buyers.

How can you use a home equity loan to upgrade your home?

Once approved for a home equity loan, you will receive a one-time lump-sum payment. You might consider having a plan for performing improvements so that you don’t spend irresponsibly.

Decide which improvements are most important. To ensure you can complete all the projects you’ve identified, you might prioritize those that will meet your goals (i.e., increase home value or create a new function) and fit within your budget.

Budget. Create an itemized budget for the items on your list. While you want to be as detailed as possible, remember that they will be estimates to start with. Include a contingency margin.

Research contractors and apply for necessary permits. Some improvements will require professional help. A permit may be necessary if you intend to add square footage, finish out a basement, or update the electrical or plumbing system. Work with your contractor to determine what you’ll need and how best to obtain needed permits.

Drawbacks of using a home equity loan

A home equity loan can work well for home improvements. Before applying, it may be valuable to consider disadvantages, too.

Using your home as collateral: A home equity loan works like a second mortgage. Your home is the collateral, so if you default, understand that the lender can foreclose on the loan and take your home.

The market’s effect on home value: Home prices have risen considerably over the past few years, increasing an average of about 20% in 2021. But prices can also decrease. If that happens, you may end up owing more money than your home is worth.

Receipt of more than you need: Lenders usually have minimum loan requirements. In some situations, this may require you to take out more money than you actually need. Budgeting and estimating for your projects before applying for the loan will help you use the funds as productivity as possible.

Additional costs. Like a primary mortgage, you will have closing costs and fees. These generally range from 2% to 5% of the principal, and include origination fees, filing fees, credit report costs, and appraisal fees. For a project that costs $30,000, for example, the total cost may be closer to $40,000 or more when you add in all the additional costs.

There’s one other option you can consider

You can finance home renovations with a home equity agreement from Unlock Technologies.

Home improvements can increase your quality of life and, often, your home’s value. When considering your financing options, you may also look at a home equity agreement (HEA).

Unlike a home equity loan, a HEA has no monthly payments or interest. Instead, the HEA provider receives a percentage of your home’s future value in exchange for cash now. At Unlock Technologies, our home equity experts are ready to guide you through the process.

Contact us today to get started.