Seeing that your home's bathroom is falling apart or that the kitchen needs remodeling is easy enough to figure out. Understanding the home improvement loan options to pay for the work can be a lot trickier.
Two common ways to finance home improvements are a home equity loan, and a home equity line of credit, also called a HELOC. Both require having some equity in your home, usually at least 10 percent.
In the end, you'll get an improved bathroom, kitchen or other area of your home to enjoy, and the home's value may go up, though not all remodeling work pays for itself by increasing a home's value.
"There is some value in updating a home for your own use," says Wendy Cutrufelli, sales and marketing administrator for the mortgage division of Bank of the West in San Francisco.
Here are some basics on how the line of credit and loan options work:
This is the most popular choice for remodeling a home, partly because the interest rate is lower than a home equity loan, and because the line of credit can be used over 10 years - called the draw period - and interest is only charged on the amount taken out in that time.
This can come in handy if you expect to take a few years to remodel your home, and aren't sure exactly how much money you'll need.
Interest rates change during the length of a HELOC, and can change at intervals such as quarterly, every six months or annually, Cutrufelli says. Current rates are about 5 percent, with a home equity loan rate 2 percent higher, she says. The worst case scenario for a HELOC interest rate is to be about as high as a credit card, around 18 percent interest, she says.
After the 10-year draw period, the borrower has 20 years to repay the entire loan, though they can refinance the adjustable HELOC rate into a fixed rate loan.
A HELOC is typically the second lien position behind a first mortgage, says Peter Grabel, a mortgage loan originator at Luxury Mortgage Corp. in Stamford, CT. Depending on a borrower's credit score and loan to value, HELOCs are offered at roughly the Prime Rate (currently 3.25 percent), Grabel says.
Although the rate is tied to the Prime Rate for the life of the loan, whenever the Prime moves, the HELOC rate will move. Prime has been at an all-time low of 3.25 percent for the past five years, but has reached 12 percent in the past, and there's no cap on the rate, Grabel says.
Pay interest only to start
Only interest is required to be paid during the 10-year draw period of a HELOC, after which the principal must start being paid. However, the borrower can pay down the balance at any time, Cutrufelli says.
For example, if $100,000 is drawn from a HELOC at 5 percent interest, the monthly payment of interest only during the draw period is $417 a month, she says. But after 10 years of paying interest only, the monthly payment would increase to $1,073 for 20 years to also include the principal.
The more equity you have in your home, the better interest rate you'll get. Someone with 40 percent equity may get an interest rate that's .25 percent lower than someone with 10 percent equity.
The total debt generally can't exceed 80 percent of the market value, says Thomas Scanlon, a certified public accountant at Borgida & Co. in Manchester, CT.
Interest tax deductible
A HELOC is considered a mortgage, so the interest paid on it is tax deductible for up to $100,000 of debt. HELOCs are often repaid as a 30-year loan.
A lender only requires a borrower to state on a lending form that the HELOC is for a home improvement, and doesn't check afterward how the money is being spent. Feasibly, a homeowner could borrow from their home's equity to pay for a vacation or buy a car. Most people use it to fix their home, Cutrufelli says, though some use it to pay for a child's college.
"The great majority of them are using it for very good reasons," she says.
While HELOCs can be used to pay for a car or consolidate debt, consumers are probably better off getting other loans for those purposes, says Charles Price, vice president of lending at NEFCU, a credit union in Long Island.
"Loan rates have been so low that that doesn't make much sense now," says Price, citing low auto loans.
HELOCs also become more popular as home prices appreciate and owners gain more equity in their homes. They're also regularly used by house flippers.
"Now they're on the upswing because people are buying properties again," Cutrufelli says.
For someone with enough equity, income and good credit, HELOCs are fairly easy to obtain, Scanlon says. There's also no costs or very little to get one, though there can be fees for running a credit report, home appraisal and closing fees. Some lenders may pay those fees for the borrower.
Home equity loan
Unlike a HELOC, where a line of credit is available any time, a home equity loan amount is determined upfront and the borrower gets it as a lump sum.
The principal and interest is paid on the full amount from the beginning of the loan, at a fixed rate that's about 2 percent more than a HELOC. The interest may also be tax deductible, depending on the homeowners' tax status.
An advantage of a home equity loan is the borrower will know the fixed payment and term - usually for 20 to 30 years - that they'll be paying. It can be a good loan for someone who knows exactly how much money they'll need for the planned home improvements, Cutrufelli says.
For people who might need money for home improvements over a long period, they might be better off refinancing their current mortgage for a larger amount, Grabel says. For short-term loans, HELOCs are an inexpensive way to borrow, he says.
Factor in 15% cushion
However you pay for a home remodel, factor in 10 to 15 percent more than you intend to use in case the project comes in over budget with an unintended expense, says Anthony Pili, director of strategic planning at Greater Hudson Bank in Bardonia, N.Y.
"During home renovations, it is very hard to anticipate exactly how much it will cost to complete the entire project," Pili says.
"I've seen customers take out too little on a fixed loan at the onset of the project and then couldn't complete due to the shortfall," he says, "...as well as customers borrowing too much upfront to avoid any risk of shortfall, but then had to pay interest on funds that they did not need and had to start paying for it before the funds were deployed to various contractors."