If you’re planning home renovations, a home equity loan can help you carry out those plans. It allows you to tap into the equity you’ve already built in your home. Home equity loans have generally low interest rates and can be used for any purpose. As an added bonus, you may even be able to deduct the interest on your loan, depending on the home improvement project.
Before using a home equity loan to improve your home, it’s important to understand the basics of how these loans work and how to know if you’re eligible for one, as well as to consider their benefits and risks.
Key Takeaways
- A home equity loan, also known as a second mortgage, is a fixed-rate installment loan that’s secured by your home.
- Home equity loans can be used for a variety of purposes, including home improvements, but only if you have a certain amount of equity in your home.
- To qualify for a home equity loan, you’ll have to meet certain equity, credit score, and debt-to-income ratio requirements.
- Key benefits of home equity loans include their fixed low interest rates and the ability to deduct some interest, while downsides include the risk to your home.
- Alternatives to home equity loans include HELOCs, personal loans, and cash-out refinances, as well as others.
Understanding Home Equity Loans
A home equity loan is an installment loan that’s secured by your home. Often called second mortgages, home equity loans allow you to borrow against the equity you’ve already built up in your home. Home equity loans usually have fixed interest rates, meaning you’ll have a set monthly payment for your entire repayment term.
Though home equity loans are secured by your home, they can be used for many different purposes, from debt consolidation to large purchases. They are often used for home improvements, as they can help increase your home’s value and offer certain tax benefits when used for this purpose.
Assessing Your Home Equity
Before using a home equity loan to remodel your home, it’s important to determine just how much equity you have. Your home equity, simply put, is the difference between the value of your home and how much you still owe on it.
For example, if your home is worth $300,000 and you have a remaining mortgage balance of $200,000, then your home equity is $100,000.
As you pay down your mortgage balance your home equity generally increases, but that’s not the only factor that can affect it. Changes in the housing market can increase or decrease your home’s market value and also impact your home equity.
Your home equity is one of the most important factors that will determine whether you can get a home equity loan. Lenders generally don’t allow you to borrow more than 80% of your home’s equity using a home equity loan.
Going back to our previous example, a mortgage balance of $200,000 on a home valued at $300,000 would mean a loan-to-value ratio (LTV) of about 67%. You would likely be able to borrow an additional $40,000, for a total loan balance of $240,000—that would bring your LTV to 80%. However, some lenders may allow LTVs of up to 85%.
How to Qualify for a Home Equity Loan
When you apply for a home equity loan, you’ll have to meet certain eligibility criteria for your application to be accepted. While these criteria may vary slightly by lender, you’ll likely need to meet three key requirements:
- Home equity: As we mentioned, lenders generally require that you maintain at least 15% to 20% of your home equity after borrowing a home equity loan, meaning a maximum LTV of either 80% or 85%.
- Credit score: There’s not necessarily a set credit score you need to get a home equity loan. Some lenders may require a score of at least 620, which is the credit score required for a conventional mortgage. Other lenders may require one that’s even higher.
- Debt-to-income ratio (DTI): Your DTI is the percentage of your gross income that goes toward debt payments. Some lenders require a maximum DTI of 43% for a home equity loan, while others allow up to 50%.
How to Use a Home Equity Loan for a Remodel
Here’s a step-by-step guide to using your home equity for a home remodel:
- Calculate your home equity: Before applying for a home equity loan, it’s important to calculate your home equity to get an idea of whether you’ll be eligible and how much you are likely to be able to borrow.
- Check your credit: While each lender has its own credit score requirements for home equity loans, it can be helpful to know your score upfront. This may help you narrow down your list of potential lenders.
- Shop for a lender: There are a variety of lenders that offer home equity loans. You may be able to get your loan from the same lender that originated your original mortgage, but it’s worth shopping around to ensure you get the best rate.
- Complete your loan application: Similar to applying for a mortgage, applying for a home equity loan requires that you complete an application with in-depth information about your personal finances, including your income, liabilities, and more.
- Get your loan approved: Once you complete your application, you’ll go through the underwriting process, during which you might be asked to provide additional information or documentation. At the end of this process, your loan may be approved.
- Receive your loan funds: Once your loan is approved, you will receive your loan funds. The entire process can take anywhere from a few weeks to a few months, but it’s common for it to take about a month to get a home equity loan.
Benefits of Using a Home Equity Loan for a Remodel
Home equity loans offer some key benefits that make them a good option for financing your home improvements. Here are some to keep in mind:
Low Interest Rates
Because home equity loans are secured by your home, they generally offer low interest rates when compared to unsecured options like personal loans. These low rates can help you save money on your home remodel costs.
Fixed Interest Rates
Unlike home equity lines of credit (HELOCs), home equity loans have fixed interest rates. This means you aren’t vulnerable to rate changes, and your monthly payment will remain stable for your entire repayment term.
Flexible Loan Use
Home equity loans can be used for a wide variety of purposes, including home improvements. While your lender may ask what the money will be used for, you generally won’t have to provide any sort of documentation.
Tax Deduction
Through the end of 2025, the federal government allows you to deduct the interest paid on home equity loans if they’re used to buy, build, or substantially improve your home.
For example, if you add an addition to your home, you could deduct your home equity loan interest.
Important
Basic home maintenance, such as repainting your home, wouldn’t be eligible for a deduction.
Long Repayment Terms
Home equity loans have long repayment terms when compared to unsecured options like personal loans. While a personal loan might have a repayment term of five or seven years, a home equity loan could have a term as long as 20 or 30 years.
Risks of Using a Home Equity Loan for a Remodel
While home equity loans have some important benefits, they also have some risks. It’s important to consider these before applying for a loan to ensure it’s still the right option for you.
Puts Your Home at Risk
Home equity loans use your home as collateral. While this often allows you to get a lower interest rate, it also means you put your home at risk. Just like your traditional mortgage, if you fail to repay your home equity loan, the lender could foreclose on your home.
Higher Rates Than HELOCs
Home equity loans have low interest rates compared to unsecured debts. However, they may have higher starting interest rates than HELOCs, which have variable interest rates. Additionally, if interest rates overall fall, your home equity rate won’t fall as your rate on a HELOC would.
Limited by Your Home Equity
The amount you can borrow with a home equity loan is limited by the amount of home equity you have. If you have less than 20% equity in your home, you may not be able to get a home equity loan at all. And if your home equity is near 20%, you may only be able to borrow a small amount.
Requires Closing Costs
Like other mortgage products, home equity loans may require closing costs (though this isn’t the case with all lenders). Depending on your lender, your closing costs could range from 2% to 5% of your loan amount. So, for a home equity loan of $25,000, your closing costs could range from $500 to $1,250.
Long Funding Time
Home equity loans can take weeks—or even months—to be completed. As a result, you may need to plan out your home improvements far in advance. On the other hand, you could get an unsecured loan in a matter of days.
Alternative Payment Options for a Remodel
While a home equity loan can be an effective tool to help you finance your home remodel, it’s not your only option. Consider these alternatives as well:
Home Equity Line of Credit (HELOC)
A HELOC is similar to a home equity loan in that it allows you to borrow against your home equity.
The key difference is that a HELOC is a line of credit, meaning you have access to a certain amount of credit and can borrow against it as needed, similar to a credit card. A HELOC has a draw period, during which you can borrow from your HELOC, and a repayment period, during which you’ll make payments on your HELOC until it’s paid off.
Lines of credit can be good tools for home improvements, especially when you don’t know exactly how much they’ll cost. Home improvement costs can be unpredictable, and a HELOC allows you to borrow more money as needed.
Personal Loan
A personal loan is an installment loan with a fixed interest rate, just like a home equity loan. The two have some key features in common, but they differ in terms of collateral.
While a home equity loan is secured by your home, a personal loan is unsecured, which results in a higher interest rate but no risk of losing your home. Personal loans can be used for any purpose and are a popular tool for financing home improvements.
Personal Line of Credit
Think of a personal line of credit as a combination between a HELOC and a personal loan. Like a HELOC, a personal line of credit offers a set credit limit that you can borrow from again and again. And like a personal loan, a personal line of credit is unsecured.
Cash-out Refinance
A cash-out refinance is another way of borrowing against your home equity. But instead of taking out a second loan, as you would with a home equity loan, you take out one large loan to replace your current mortgage.
The new mortgage you take out is larger than the balance on your original mortgage, and you receive the difference in cash, which you can use for any purpose.
A key benefit of a cash-out refinance is that you enjoy the low rates usually associated with mortgages. However, if interest rates have increased since you got your original mortgage, it could end up being very costly.
Credit Card
A credit card isn’t normally a good alternative to a loan for a large expense such as home renovations. However, an exception might be if you could qualify for a 0% APR offer and you feel confident you can repay the full balance before that offer period ends.
Frequently Asked Questions (FAQs)
Is a Home Equity Loan a Good Idea for Renovations?
Home equity loans can be a good idea for renovations because they offer low interest rates, the interest can be tax-deductible, and the renovations may increase your home equity. However, a home equity loan isn’t right for everyone, so it’s important to weigh the pros and cons.
How Much Equity Do You Need for a Renovation Loan?
Depending on the lender, you’ll usually be required to maintain at least 15% to 20% equity in your home after taking out a home equity loan. If you currently have less equity than that, you may not be able to get a home equity loan.
Is a Home Equity Loan the Same as a HELOC?
Home equity loans and HELOCs are similar in that they both allow you to borrow against your home equity. However, they are structured differently. A home equity loan is an installment loan with a fixed interest rate, while a HELOC is a line of credit with a variable interest rate.
Are Home Equity Loans Tax Deductible?
The interest on home equity loans may be deductible in some situations. Until the end of tax year 2025, you can deduct the interest on the portion of your home equity financing that was used to buy, build, or substantially improve your home.
The Bottom Line
A home equity loan can be an effective tool to help you pay for home improvements. Home equity loans offer some key benefits, including low interest rates, long repayment terms, and more. They are also uniquely suited to home improvements because not only could you ultimately increase your home’s value, but you can also deduct the interest if the money is used for certain projects.
Before getting a home equity loan for your remodel, be sure to weigh the pros and cons of these loans, find out if you’re eligible, and consider alternative financing methods that could be a better fit.
Read the original article on Investopedia.