When you first moved into your home, you probably did some projects to make it more your own such as painting and landscaping. Major improvements like fixing up your bathrooms and kitchen add the most value to your home. But in reality, most of us don’t do anything more than routine maintenance, unless we’re getting the house ready to sell. But why wait? Instead, make those improvements now so you can be the one to enjoy the changes.
If you’re wondering how to pay for those projects, a home equity line of credit (HELOC) can be a great tool.
What is a HELOC?
There is a connection between a HELOC and the value of your home. It offers benefits of a second mortgage loan including reasonably low interest rates and borrowing power that increases as your home’s value increases. Depending on your tax situation, you may also be able to write off the interest, just like with a first mortgage. (Consult your tax adviser for more information on that).
The amount you can typically borrow for any second mortgage (HELOC or home equity loan) is the current appraised value of your home minus your first mortgage within your lenders’ required loan-to-value ratio (LTV). Subject to the type of loan you’re getting and your equity situation, your lender may only approve against a certain percentage of it (typically between 80 percent to 90 percent) — that’s the LTV. For example, your home is worth $500,000 and you currently owe $200,000. Your lender says you can borrow up to 80 percent LTV, which means you could borrow as much as $200,000 ($200,000 mortgage + $200,000 HELOC = $400,000 [80% of $500,000]).
A HELOC can be more flexible than a home equity loan, though, because you take the money out when you need it and make payments based only on what you’ve spent from the line of credit. For example, if you have a $200,000 home equity loan, you’d make fixed payments on the entire amount for the life of the loan. If you aren’t using the entire amount, you may be paying more in interest than earning on the lump sum. However, if you have a $200,000 HELOC and you use $50,000 to renovate your kitchen and bathroom, you’d make payments only on the $50,000 you’ve borrowed. If you need the rest of the line of credit for other projects, it will still be accessible during the draw period.
When does a HELOC make sense?
A HELOC is a loan against your home, so you want to make smart decisions when offering your home as collateral. What types of expenses does a HELOC make sense for?
One main reason to apply for a HELOC is home improvements. We talked about how we’ve seen so many people wait to make improvements until they’re getting a home ready to sell. But some improvements don’t return their entire investment, even though they may be necessary. Instead of making your house better for the next family, why not take time now to make it better for you?
Consider the things you wish worked differently. The kitchen could use more counter space. The bathroom is just unappealing. The attic or basement could use a little freshening up to make it a usable — and enjoyable — space. Or there’s the bonus room that would make a great home office.
Create a budget to lay out changes you’d like to make and how much you may need to borrow to make them happen. And consider some of the hidden projects in these home improvements. These could include upgrading wiring to serve a home office, additional attic room, or the improved pipes for a new bathtub.
Even though you’re not doing this mainly to recoup your investment, it’s a good idea to focus on improvements that will add value. Many sources recommend bathroom and kitchen remodeling, along with outdoor landscaping as a high return on investment. So those projects may be worth investing in by hiring professionals and spending a little more on better quality materials.
Debt consolidation is also a common use of a HELOC. If you’re struggling to pay debts because of high interest rates, consolidating them into a HELOC can help you pay them off sooner and save money on interest. But this use may not be a good fit for everyone. Before deciding to tie these debts to your home, make sure you’ve addressed the situations or habits that got you into debt in the first place. If there’s a temptation for you to continue using those cards once you’ve paid them off, consider closing some of them (Partners can help you make smart credit decisions —contact us to learn about your options).
You can also use a HELOC for education or travel. And the interest rates are usually better than credit cards. But, again, be careful when tying your home to this type of expense. Make sure you have a plan to pay it off in a reasonable amount of time.
When a HELOC doesn’t make sense
When should you avoid borrowing against your home? A HELOC is not a good choice for everyday home expenses or small DIY projects. You will want to make sure your regular monthly income can cover those things. You also don’t want to use a HELOC to buy a car, recreational vehicle, or boat. It’s best to use a vehicle, RV, or boat loan for those purchases, so the collateral is the item itself and not your house. Difference in interest rates may be negligible, and if you use a HELOC for a non-home purchase, the interest from that transaction may not be tax-deductible (again, talk to your tax professional about deductions because he or she knows your specific situation and can give advice).
Curious about whether a HELOC is right for you and how you can get one? Let us know. We’re here to answer your questions.