Should I Take Out a Home Equity Loan to Remodel My House?

If you're a homeowner with a mortgage, you likely have equity built up in your home. This equity represents the difference between the value of your home and the amount you owe on your mortgage. A home equity loan allows you to borrow against your home's equity at generally favorable interest rates.

But is it the right financing option for you? Here's what you need to know if you're wondering whether you should take out a home equity loan to remodel your house.

How home equity loans work

A home equity loan is a secured loan, which means your home is considered collateral. Because the loan is secured against the equity built up in your home, it offers a competitive interest rate similar to that of a primary mortgage. Generally, you can expect a home equity loan to have the lowest interest rates of any loan you might take to cover the costs of home improvement.

However, if you don't have much equity built up in your home, a home equity loan may not provide you with the amount of capital you need to cover your renovations. And if you default on it, you may find yourself in danger of losing your home.

Benefits of a home equity loan for a remodel

You might choose to take out a home equity loan for your planned remodel for several reasons. To start, the low interest rate of a home equity loan can make it one of the least expensive ways to cover your home improvement project. If you have an expensive remodel in mind, taking out this type of loan could give you the biggest bang for your borrowed buck.

Additionally, the IRS offers a tax deduction on the interest you pay on a home equity loan if you use the funds on home improvement. This deduction can reduce your taxable income, lowering the tax burden for the years you're still paying interest on the loan.

By providing these options, mortgage lenders and Uncle Sam are trying to encourage the use of home equity loans to help you improve your home, ultimately increasing its value. Considering how much additional value you can add to your home may help you decide whether you should take out a home equity loan for your planned remodel.

Drawbacks of a home equity loan for a remodel

A home equity loan can include some potential costs and drawbacks. Because your home is used as collateral, you risk losing your home if you default on the loan. You may also face a serious problem if your home's value decreases suddenly, as many homeowners experienced in 2008 when the housing bubble burst.

If your home value falls to the point where your loan balance is greater than the value of the house, the bank could call in the loan, requiring you to repay all or most of it at once. Failure to do so could again result in the loss of your home. Both of these are serious consequences that every homeowner needs to recognize and consider before taking on such a loan.

Other financing options

Home equity loans aren't necessarily right for everyone. For instance, if you're looking to make smaller or lower-cost improvements, you may find that a home equity loan is too big for your needs. Other funding options available include:

• Home equity line of credit, or HELOC: Like a home equity loan, a HELOC allows you to tap into your equity. The difference is that instead of receiving a lump sum, you get a line of credit to access as needed, meaning you don't have to take more money than necessary for your remodel. HELOCs also tend to have lower interest rates than home equity loans.
• Home improvement loan: These unsecured loans have a shorter approval process than home equity loans and can allow you to access up to $75,000 as quickly as the next day. They also have shorter repayment terms and higher interest rates than home equity loans.
• Cash-out refinance: You can potentially reduce your mortgage interest rate or monthly payment amount by refinancing with a cash-out option, which you can then use for your remodel.

A home equity loan can be a savvy way to afford your renovations. Understanding the potential costs and benefits of a home equity loan can help you make the best decision for your home improvement plans.