Using the equity in your home to pay for a remodel can make financial sense.
Both a home equity loan and a Home Equity Line of Credit (HELOC) are good options, but there are important differences that may make one or the other the best choice for you.
Just because a bank may lend you a certain amount of money doesn’t mean that you should borrow that much. Review your budget and do the math before you decide.
We've owned our home for five years and have reasonable equity in it. We now want to remodel our kitchen and are considering different ways to help pay for it. Is a HELOC a good choice?
Home renovations are exciting—and expensive. Depending on where you live and, of course, your tastes, I've seen estimates for kitchen remodels running anywhere from $20,000 to $100,000 or more. So planning in advance how best to pay for it is a smart first step.
In an ideal world, you would be able to save up enough money to finance your remodel. However, assuming that isn’t possible, and that you have enough equity in your house to borrow against, a home equity line of credit (HELOC) can be a good choice. Alternatively, you could consider a standard home equity loan. One of the benefits of either loan is that you can deduct the interest expense on up to $100,000 of home equity debt secured by your home. However, there are a couple of significant differences between the two types of equity loans, so I think it's wise to at least look at both before you decide.
The difference between a home equity loan and a HELOC
A home equity loan is similar to a regular mortgage. You borrow a specific amount and make monthly principal and interest payments on the total for a specified period of time. Often you can get a fixed interest rate for a home equity loan, but you may also have to pay closing costs and other fees.
A HELOC is more like revolving credit. You're approved to borrow up to a maximum amount for a certain period of time (usually 10 years), but you choose when and how much to borrow according to your needs. Interest rates are variable and closing costs are usually minimal. You only pay interest on the amount you borrow—and you can generally choose to make interest-only monthly payments for the term of the loan. At the end of the term, you can either pay off the total or switch to principal plus interest payments.
With either loan, the amount of equity you have and your credit score will determine the type of deal you get. The more equity you have, the higher the potential loan amount. The better your credit score, the lower the interest rate.
What's the better choice?
Whether one type of loan or the other is better for you depends on whether you prefer more certainty in your loan and payment or more flexibility. When looking at something like a home renovation, the flexibility of a HELOC could make sense for two reasons: 1) You can withdraw only what you need to pay off contractors, and 2) You save because you're only charged interest on what you withdraw. Also, with a HELOC you have the option of making interest-only payments—although you need to be careful not to get in over your head with that approach.
What to look for in a HELOC
If a HELOC sounds right for you, you'll want to do some comparison-shopping. Here are a few things to consider:
- Interest rates—These vary by lender. Rates are usually tied to an index such as the prime rate but lenders also charge a mark-up. Even a small percentage difference in a mark-up can mean a higher cost to you over time. Also beware of teaser rates. To get your business, a lender may have an introductory offer. Be sure you understand how long that offer lasts and how much your rate will go up at the end of that introductory period.
- Rate caps—Because HELOCs have variable rates, if and how those rates are capped are important. Some lenders have a maximum interest rate cap for a specific period of time. Others have a cap on how low a rate can go. Both can be significant as rates rise and fall.
- Draw period—This is the amount of time you can withdraw money before you have to start paying back the principal. Ten years is a common draw period.
- Balloon payments and pre-payment penalties—Be sure you understand what happens at the end of the draw period—how much you'll owe and when. Just as important, make sure there's no prepayment penalty should you want to pay off your balance sooner.
- Minimums and fees—There may be minimum balance and withdrawal requirements. Likewise, a lender might charge inactivity fees.
How much you'll get—and what you'll pay
The general formula used for determining how much a bank will lend you is a percentage of your home equity minus your current mortgage. So let's say your home is appraised at $500,000, your current mortgage is $300,000 and your lender will let you borrow up to 80 percent of the value of your home. Your maximum loan would be $100,000 ($500,000 x .80 - $300,000).
That said, just because a bank may loan you that much doesn’t mean that you should go that high. A prudent guideline is that your monthly home debt obligations shouldn’t exceed 28% of your gross income.
Continuing with the math, let's say that the interest rate on your HELOC is 4 percent. In that case, an interest-only monthly payment would be around $333 per month during the ten-year draw period for a $100,000 loan. A fully amortized monthly payment (paying off principal as well as interest) would be about $1,000. Of course, in either case, if interest rates go up over 4%, you'll pay more. Also, when the ten years are up, you’ll need to either pay off the loan or pay a much larger monthly amount to cover interest plus principal.
So before you decide on the amount you can borrow, be sure to carefully think through your current budget—and if you go the interest-only route, be sure to look down the road when the principal will be due.
Preparation is the key to making a good choice. You don't want to be caught by surprise on any of these variables. Myfico.com is an excellent resource for more information to help you understand and compare home equity loan options. Do a bit more research, and then when talking to a lender, don't hesitate to ask all your questions. You'll feel better about your loan choice—and you’ll enjoy your new kitchen even more!
Have a personal finance question? Email us at firstname.lastname@example.org. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.