Renovation projects such as adding a fence, replacing a roof or remodeling your kitchen or bathroom are a good way to maintain or increase the value of your home, but they can be costly. Tapping into the equity of your home through a loan to finance these projects can be an affordable alternative to turning to your credit cards or other higher-interest options.
Whether you are renovating a home to sell, rent or continue living there, a home equity loan is one of the several financing options available to you from your bank, credit union or an online lender.
What is a home equity loan?
A home equity loan, a secured loan known as HEL, is one of the most common options for homeowners to fund their home repairs or renovations. Under a home equity loan, an individual can tap into the equity of the house and use it as collateral.
The money you receive from a home equity loan is given by a lender as a lump sum, which can be a benefit if you are working on a larger renovation project and need to pay construction workers, electricians or plumbers as well as cover the costs of building materials, appliances or other supplies.
Another advantage is that the interest rate on a home equity loan is fixed and will not change during the term of your loan. This helps homeowners estimate how much cost they can afford with their project and how much their monthly payment for the loan will be.
One major drawback, however, is that if a homeowner is unable to pay back the loan, the lender could choose to foreclose on the house because it is being used as collateral.
Using a home equity loan for other purposes such as consolidating your credit cards, student loans and or other debt can be risky for this reason, if your income changes or you are unable to make payments on the loan.
What options do you have for home equity loan terms?
Homeowners typically have three options for home equity loans — the shortest length of time is a five-year term, while 10- and 15-year loans are also common. One benefit is that you can choose to pay off the loan early, similar to making extra payments toward a 30-year mortgage. Paying off a loan earlier will save you money in interest, but check to make sure your loan does not have a prepayment penalty.
Shopping around can help you receive the best home equity loan terms. A home equity loan is similar to seeking a mortgage or refinancing one because you will have to pay closing costs such as a title search, home appraisal, application fee and document preparation — fees that can add up to 2% to 5% of the total amount of the loan.
You can determine the amount of equity you have in your home by plugging in the appraised value of the property and the amount of money you still owe on the mortgage with this online calculator.
Choosing between a 5-year and 15-year home equity loan
Five years is typically the shortest term you can get for a home equity loan because paying back a $20,000 or $50,000 loan over a few years can be really expensive, possibly more than your monthly auto loan bill. Your monthly payments would be very high if the term were shorter than five years.
A five-year loan can be an ideal option for someone tackling a smaller renovation such as a bathroom — not taking out a large loan and wanting to pay less in interest.
A home equity loan that you will pay back within five years is typically cheaper than other types of debt. The average rate for a 15-year fixed-rate home equity loan is currently 5.76%, but the rate depends on your credit score and history and does not include closing costs.
By comparison, the current rate for a personal loan will range from 10% to 28% in 2019, also dependent on many factors, including your credit score and the amount and length of the loan.
The interest rates for credit cards are also higher than a typical home equity loan and can range from 12% to 29%, depending on your credit score.
Depending on the duration of your home repairs or remodeling project and its costs, it could be beneficial to have a longer time to pay back the loan, such as choosing a 15-year home equity loan option.
Major renovations such as adding a room or gutting the majority of an older house can be expensive and easily run $100,000 or more. When you borrow a large amount of money, it is not easy to pay it back within five years, so a 15-year home equity loan makes more sense in that case.
If you live in a neighborhood or city where the home values have risen significantly in the last few years, getting a larger loan can make sense.
Even if you are undertaking a smaller home repair such as renovating a bathroom, a longer term for a loan can help your budget because your monthly payments will be smaller and more affordable. You can spread out the loan payments over time, which means you will have more cash on hand in case of emergencies or if the project costs more money than you estimated. This approach will ensure you can make all your payments but will cost more in interest. And remember: Missing payments can result in a foreclosure.
If your project is expensive and you need more than 15 years to repay the loan, a cash-out refinance might be a better option. This type of refinancing means you will use your home as collateral and will replace your current mortgage with another one. The difference between the two mortgages will be given to the homeowner in cash. It is similar to a home equity loan because you will receive the money in a lump sum and the interest rate can sometimes be lower than your initial mortgage.
The drawbacks for a cash-out refinance are that you are starting another mortgage that likely will take longer to pay off, and the closing costs are usually higher.
Shop around and compare rates — the interest rates for home equity loans range between 4% to 5.87% annual percentage rate (APR), compared with cash-out refinance rates of 4.1% to 4.3% APR. Refinancing is often cheaper, but both are secured loans and use the amount of equity in your home as collateral.
If you are torn between the two choices, this article provides more factors you should consider.
Alternatives to home equity loans
A common alternative to a home equity loan is a home equity line of credit, known as a HELOC. Instead of getting a lump-sum payment, you draw down on the loan like a credit card when you need it. This could be a helpful option if you are working on a series of smaller projects over time.
Because you choose when you need the funds, you only make payments once you start withdrawing money. You also do not pay interest until you start borrowing money from the HELOC.
While there are a variety of ranges on the terms of a HELOC, they are typically 20 years. You have 10 years to borrow money from your line of credit and the next 10 years to pay back the loan.
The drawback to HELOCs is that the interest rates are variable and you could face higher monthly payments some years, which could hit your monthly budget. Many HELOCs also allow borrowers to only pay the interest during the “draw period,” or those first 10 years. This means your monthly minimum payment could rise quickly and hamper your budget if you are on a fixed income.
Both personal loans and credit cards are options that do not consider the amount of equity you have in the home. They could be a short-term option for a major, but unexpected repair such as a leaking roof or broken air conditioner or heater. But these options are expensive and could affect your credit score if you are unable to make the monthly payments.
Remodeling your home can help add value to the property, making it attractive for potential buyers or renters. After you create a budget to add a room or to update the kitchen, consider all your lending options. A home equity loan could be an affordable choice, especially if you have a large amount of equity because you have lived there for many years or the value of the home has risen. Using the equity in your home can be a cheaper way to borrow money, but determine ahead of time if you can take on another bill each month.
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