If you have equity in your home, you may consider tapping into it to renovate your home. While it can be a good idea sometimes, it’s not always a great idea. Whether or not you should consider it depends on your current situation.
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Keep reading to help you figure out if you should tap into your home’s equity.
Two Ways to Use Your Home’s Equity
First, there are two ways that you can use your home’s equity. You can refinance your first mortgage with a cash-out refinance. This program gives you access to the equity in your home in one lump sum. You can usually borrow up to 80% of the home’s value, receiving any ‘extra’ funds that you don’t need to pay off your current mortgage in hand. You’ll make regular principal and interest mortgage payments starting with your first payment.
You can also opt for a Home Equity Line of Credit. This is a second mortgage or second lien on your property. Many lenders allow you to borrow up to 85% of your home’s value with a HELOC. Rather than receiving all of the funds in one lump sum, the lender places the funds in a bank account. You can then withdraw the funds with a credit/debit card or check. You pay interest only on the funds that you withdraw for the first 10 years. If you repay some of the principal, you can reuse the funds during this time. After 10 years, you go into repayment mode, which means you pay principal and interest on any money you withdrew. You make these payments for the next 10 years.
The Deciding Factors
So how do you know if you should use your home’s equity for either of the above loans? Consider the situations below:
- You can get a cash-out refinance for an interest rate lower than you have currently – This is the ideal situation. You can refinance your first mortgage and tap into your home’s equity, still paying less interest on the loan. You should also have a similar mortgage payment so that you don’t see much of a difference on a monthly basis.
- You can’t get a lower interest rate on the cash out refinance – In this case, using the second mortgage possibility is better. Typically, interest rates on HELOCs are lower than first mortgage loans, which will give you the chance to save on the interest on the extra money you need to borrow.
- You have multiple needs for the cash – If you are working on projects that are long-term and don’t have a concrete cost yet, a HELOC may be the better option. You won’t pay interest on the money that you don’t withdraw. If you won’t use all of the funds right away, why pay interest on them yet? The HELOC helps you save money while you put the plans in place and make them happen.
The Benefit of Using your Home Equity for Renovations
There’s one distinct benefit of using your home equity to make home renovations. You’ll likely increase the value of your home. Now not all renovations have a great effect on your home’s value, but if you make renovations like kitchen or bathroom renovations, they will affect your home’s value in a good way.
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If you talk to a professional appraiser, contractor, or real estate agent, you can figure out which renovations would have the greatest effect on your home’s value. This way you could focus on those areas in order to increase your home’s value. When you sell your home, you’ll be able to sell it for a larger price, paying off both mortgages and walking away with money in your pocket.
A few other distinct benefits of using your home’s equity include:
- You can typically get a decent interest rate whether on a cash-out refi or a HELOC
- You may be able to write off some or all of the mortgage interest that you pay
- You get a long time to pay it off (up to 30 years depending on your loan’s term)
The Downside of Using Your Home’s Equity
There are a few downsides of using your home equity to make home renovations:
- You may increase your mortgage payment. If you aren’t lucky enough to get a low interest rate, you could end up with a higher mortgage payment than you had before.
- You could lower your savings rate if you have to pay a higher mortgage payment and take away from the money that you save.
- You will pay closing costs, which can eat away at the benefits of the refinance. If you pay too many closing costs, the renovations could become much more expensive.
In order to tell if you should use home equity for your home renovations, you need to look at the big picture. How much will the new loan cost you each month? What will the total closing costs be? How much will the loan cost you over its entire term? You can use these numbers to tell if using your home’s equity is worth it or if you should find another way to get the cash you need for a home renovation.
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