Before tapping into your home equity consider the pros and cons that come with taking out a loan for home improvement. (Dreamstime/TNS)

The amount of equity you have in your home is the portion of your home that you’ve already paid off. If your house is worth significantly more than what you still owe on your mortgage, you may be able to use that equity to pay for home improvements or renovations.

But before tapping into your home equity consider the pros and cons that come with taking out a loan for home improvement. Read on to learn more about your options and how you can make the most of your home equity loan or home equity line of credit (HELOC).

Benefits of using the equity in your home for home improvement
Home equity can be a smart way to finance a remodel, especially as interest rates remain low. As of early January 2022, the average home equity loan rate is 5.96 percent APR, and the average HELOC rate is 4.27 percent APR.

Tax deduction
The interest you pay on home equity loans and HELOCs is tax-deductible but there are important limits to understand before proceeding. To begin with, the money must be used to substantially improve the home that secures the loan. It cannot be used for such things as personal living expenses or to pay credit card debt. Substantial improvements are changes or renovations that add value to the home, or prolong its useful life or even adapt the home for a new or different use.

There are also limits on the loan amount when it comes to qualifying for an interest deduction. As of 2018, joint filers may deduct interest on up to $750,000 worth of qualified loans, while single filers or married filers filing separate returns can deduct interest on up to $375,000. These figures represent a reduction from prior limits of $1 million for joint filers and $500,000 for individual tax returns.

You must itemize tax returns in order to earn the deduction.

Low interest rates
Both home equity loans and HELOCs carry low interest rates because they use the home as collateral for the loan. Obtaining the most competitive rates however will depend on your financial situation.

Those who have good credit will have access to the most competitive rates, while applicants with less-than-ideal credit scores will pay a higher rate. In general, a credit score of above 700 will most likely qualify you for a home equity loan, as long as other application requirements are also met.

It’s important to shop around and check rates from a variety of lenders to ensure that you’re getting the most favorable rate based on your financial history.

You can also work on improving your credit score prior to applying for a home equity loan or HELOC to help improve your odds of securing a competitive rate. This can be accomplished by paying down outstanding debt, consistently making on time payments and disputing any negative items on your credit report.

Return on investment
Investing in your home is a smart idea, whether you’re looking to sell or create a more comfortable space for you and your family. If you’re considering selling your house, renovations may help it sell more quickly and for more money.

Drawbacks of using a home equity loan for home improvement
While there are many benefits to taking out a home equity loan for home improvements, it’s important to remember that there are also drawbacks.

• Your home is collateral for the loan
Perhaps the biggest drawback to consider before signing on the dotted line for a home equity loan is the risk of losing your home should your financial situation change unexpectedly. If you fall behind on payments, your home could be foreclosed upon.

Consider your financial situation carefully before proceeding. This includes thinking about your employment situation, your current level of debt and other factors that may impact your ability to remain up to date with the loan payments. Be honest with yourself about whether your financial situation is stable enough to maintain regular payments for the long haul.

It can also be a good idea to speak with a financial advisor who can help crunch the numbers and determine whether a home equity loan is right for you. This type of professional can also help you develop a financial plan that allows for successfully meeting the demands of loan repayment.

• The value of your property could decline and the bank may recall the loan
While home prices are soaring right now, that may not always be the case. From time to time there are substantial market corrections or downturns. The Great Recession in 2008 for instance, caused a housing crisis and many owners were suddenly upside-down in their mortgages – owing more than the fair market value of the house.

A market downturn can be especially challenging if you have a lot of debt associated with the home, says Mark Charnet, founder and CEO of American Prosperity Group, a retirement and estate planning firm.

“If the value of the home falls to where the loan balance exceeds the home’s value, the bank may call in the loan and force you to pay it all off or a significant amount of it,” Charnet says. “Failure to do so can possibly lead to a foreclosure action by the lender. Never loan yourself so much that a 5 to 7 percent reduction in your home’s value will trigger this type of ‘underwater’ event.”

With such concerns in mind, it is important to never borrow more money than you will need when taking a home equity loan or HELOC. It’s also important to be sure the renovations you are embarking upon will actually increase the home’s value.

• A home equity loan might be more than you need
Using home equity for home renovations works best when you’re making significant improvements or have multiple renovation projects that will be covered with the loan funds. Often lenders have minimum borrowing requirements, which means you’ll need to be prepared to take out a substantial amount of money, more than you may feasibly need to use.

“A home equity loan can be a great option for borrowers if they’re looking to cover a large expense,” says Nicole Straub, general manager of Discover’s home loans unit. “Loan amounts tend to be higher than for unsecured loan products like personal loans.”

If you have smaller projects or renovations in mind, it may not make sense to take a loan that not only involves high minimum borrowing amounts but also includes closing costs and requires putting your home on the line as collateral. A personal loan or even a credit card may be a better choice for such circumstances.

• The loan comes with additional costs
Because a home equity loan is a second mortgage, you’ll pay closing costs and fees, which can be expensive, ranging from 2 percent to 5 percent of the loan, Sterling says.

“If you’re planning a $30,000 kitchen remodel, you will end up paying much more than $30,000 in interest, closing costs and other fees,” she says. “If you have a home equity line of credit, you also run the risk of interest rates rising.”

The fees associated with this type of loan include origination fees, appraisal fees, document and filing fees, credit report fees and more. It’s important to factor these fees into the total cost of the loan when deciding it makes financial sense for your situation and needs.

Home equity loans vs. HELOCs for home renovation
Two of the most popular options for borrowing money for home renovations are home equity loans and home equity lines of credit. The two share many similarities: they both use the equity in your home, they both use your home as collateral and they both typically let you borrow up to 80 percent or 85 percent of your home’s value, minus your outstanding mortgage balance.

However, the two have several differences, and they each have their pros and cons.

Home equity loans for home improvement
Home equity loans are structured more like a traditional mortgage, with a set schedule of payments that include both principal and interest. They are essentially second mortgages and typically come in terms of 10, 15, 20 or 30 years.

• Payments are structured and begin right away, which makes it easier to budget.
• Home equity loans usually have a fixed rate, so the amount you pay will likely stay at or close to the same amount each month.
• If you aren’t planning to start remodeling immediately, you can move the money to an interest-bearing account and earn money on your money.
• All money is disbursed up front, making the loan a good option for large-scale improvement projects.

• If your home remodeling project is going to be a lengthy process, you may be tempted to spend the money on other things instead.
• A home equity loan is a secured loan against your house, so if you stop making payments, the bank can take possession of your home.
• If home values take a dive, you may owe more on your loan than the home is worth.
• Since a home equity loan is a second mortgage, it comes with closing costs and fees.

Home equity line of credit (HELOC) for home improvement
All HELOCs have a draw period and a repayment period. During the draw period, you can borrow money from the line of credit and may only be responsible for interest-only payments. Once that period expires, you can no longer withdraw funds, and you must start repaying both principal and interest.

• You can use as much or as little money as you need and only pay back what you use.
• Interest rates are usually lower than those of personal loans or credit cards.
• During the draw period, you may be given the option to make interest-only payments.

• HELOCs are variable-rate loans, which means the interest you pay will fluctuate and affect your monthly payments.
• It can be easy to take on more debt than you can afford since you can borrow from your HELOC multiple times and don’t have to start paying principal right away.
• Many lenders charge an annual fee to keep the HELOC open, whether you use it or not.
• If home values fall, you may owe more than the home is worth.
• It can take a bit longer to get approved for a HELOC than a home equity loan.

5 ways to use a home equity loan for home improvement

1) Kitchen remodel
Kitchen remodels are the fifth-most popular project in the country among homeowners planning renovations in 2021, according to HomeAdvisor’s 2021 True Cost Report.

In addition, according to Remodeling’s 2021 Cost vs. Value report, minor kitchen remodels with midrange finishes recoup 72.2 percent of their cost in home value.

“Because of the relatively higher cost of kitchen remodels, financing these projects with lower-interest home equity loans could be a great way to improve your home value,” says Mischa Fisher, chief economist for Angi, the service that powers HomeAdvisor.

2) Bathroom remodel
Bathroom remodels also provide a relatively good return on investment, with 60.1 percent of a midrange remodel’s cost recouped, according to Remodeling’s 2021 Cost vs. Value report.

“Bathroom remodels were the most-planned project for 2021 in the HomeAdvisor True Cost Report, but they also carry a high average cost of $13,401,” Fisher says. “Since that is more cash than most people would like to pay upfront, bathroom remodels could be one of the best options for financing.”

3) New deck
Decks have seen one of the most significant increases in popularity of the major projects tracked by HomeAdvisor’s True Cost Report, rising from the 10th-most completed project of 2020 to the seventh-most planned project of 2021.

They also provide a solid return on investment, according to Remodeling’s 2021 Cost vs. Value report, with wood deck additions recouping 65.8 percent of their value and composite deck additions recouping 63.2 percent.

4) Garage door
Replacing your garage door practically pays for itself, recouping 93.8 percent of the cost, according to Remodeling. That put it at the top of the list for retained value at resale.

5) Roof replacement
A roof replacement is a wise investment, Sterling says. An asphalt shingle roof can provide a return of 60.7 percent, according to Remodeling’s 2021 Cost vs. Value report.

“Like garage doors, this may also be a necessity if you have an old or damaged roof,” Sterling says. “You also get a better return on shingles as opposed to metal roofs.”

Alternatives to home equity loans for home improvement
If you’d rather not use your home equity for home improvement projects, you have other options:

• Personal loans: Because personal loans are unsecured debt, interest rates range from about 2.49 percent to about 36 percent, depending on your credit history, income and other factors. However, a personal loan can be a useful short-term solution for remodeling when you don’t have much equity but the improvements you are planning will significantly increase the value of your home. Though rates for personal loans are higher than those of home equity loans, you don’t risk losing your home if you default.

• Credit cards: If you have discipline and excellent credit, you may qualify for a credit card offering a 0 percent interest rate for a certain term. If you qualify for a credit card with a 0 percent interest promotion, it can mean financing a home improvement with no interest, provided you can pay the credit card off before the promotional term ends. Interest rates can and will go up if you are late or miss a payment, and they can reach astronomical levels.

• Cash-out refinance: With a cash-out refinance, you refinance your mortgage for more than what you currently owe, replace your current mortgage with a new one and take the difference in cash. Keep in mind that cash-out amounts may be limited, and this option is only smart if you can get a lower interest rate on your mortgage. Before committing, get quotes from a few lenders offering refinancing.

The bottom line
If you’re looking to renovate your home, tapping your home equity may be a good way to find funding. Shop around at multiple lenders to find the best deal on a home equity loan. Home improvement projects can be expensive enough, and even a small difference in the interest rate can save you thousands of dollars over the years.

By Natalie Campisi, (TNS).