Renovation financing affects your return on investment (ROI), so it’s a critical factor to consider when you upgrade your property. For instance, the less interest you pay, the more you’ll make when you sell your home. So even if choosing a home-improvement loan isn’t as fun as selecting fixtures or flooring, it’s important to understand your financing options before you commit. If you’re unsure about whether you should take out a home equity loan or a home equity line of credit (HELOC), here’s what you should know.
What Is a Home Equity Loan?
A home equity loan is a mortgage that’s secured by the borrower’s property. The application process is similar to that of a first mortgage, requiring an appraisal, credit report, title insurance and verification of income. At closing, the borrower receives a lump sum, and then pays it back in monthly installments. Home equity loans usually (but not always) come with fixed interest rates, and you usually can’t borrow against all of your equity — loan programs typically let you finance 80 to 90 percent of your property value, but there are a few lenders willing to go higher for clients with excellent credit. Keep in mind that for better or worse, the terms of a home equity loan cannot be changed once the final paperwork has been recorded and the money has been handed over.
What Is a Home Equity Line of Credit?
A HELOC is also a mortgage, but it’s not an installment loan. Instead, it’s a revolving line of credit that you may use and reuse during its term. You could say that a HELOC is like a big credit card. However, unlike a credit card, a HELOC is secured by your home. That is both a blessing (because it’s backed by your home equity, HELOC interest rates are much lower) and a curse (if you fail to repay your HELOC as agreed, your lender can foreclose on your house). HELOCs also cost less to originate (up to a few hundred dollars), and the application process is usually simpler and faster than that of a home equity loan.
HELOCs come with variable rates, which are based on an economic index, like the prime rate, and can change every month. Your monthly payment is based on the balance owed and the interest rate, and you only pay interest on the amount of credit you actually use. HELOCs have two phases, a drawing phase, during which you may withdraw as much and as many times as you want, up to your credit limit, and a repayment phase. In the repayment phase, you may not withdraw any more money, and you must make monthly payments until the balance is zero. Some lenders allow you to convert your variable rate into a fixed rate during the repayment phase.
Which Is Better?
When you look for renovation financing, your remodeling strategy, budgeting ability and tolerance for risk determine which option is better for you. Here are some more tips to help you choose the best option for you:
If you’re planning a series of small do-it-yourself projects over the upcoming months or years, perhaps completing some energy-saving green renovations or adding trendy features to your kitchen, a HELOC is probably the better choice for you. With this loan, you withdraw and pay interest on only the amount you’re using. You can even maximize the benefit of a rewards credit card with a HELOC. Just use the credit card to buy your supplies and equipment, and then pay the card balance with a check from your HELOC. This also allows you to take advantage of your credit card’s grace period and reduce the interest you pay.
HELOCs are preferable for borrowing smaller amounts because their up-front costs are lower. If you need $10,000, for example, and it costs $1,000 to originate a home equity loan, that cost is 10 percent of the loan right off the bat. Your HELOC lender, on the other hand, might originate your loan for free if you’re willing to accept a prepayment penalty.
It’s important to also understand that HELOCs come with a few disadvantages. The variable interest rate means you could end up paying a lot more for your upgrades than expected, and variable payments are unpredictable, which makes budgeting more difficult. Finally, if you’re in the middle of your project and your credit rating or home value drops, your HELOC lender could reduce or even freeze your credit line. If this happens after you’ve removed an exterior wall, but before you’ve replaced it, you’ve just derailed the entire project.
- Home Equity Loan
If you’re planning to invest in a major project, like a top-floor master suite or a new guest house, you’ll probably need a substantial up-front sum. For larger amounts of money, home equity loans offer benefits that HELOCs don’t offer. Arguably the biggest advantage is that the fixed interest rate and payment makes budgeting a lot easier. In the current mortgage environment, interest rates are still near historical lows, and it makes sense to grab them while you can. While introductory interest rates and up-front costs for HELOCs are often lower than those of home equity loans, their interest rates and payments can (and often do) increase over time.
Another advantage of home equity loans is that once you have your money, it’s yours to keep. Even if your credit rating drops and your home’s value falls, there’s nothing your lender can do as long as you make your payments. For all of these reasons, home equity loans are considered safer than HELOCs for the average homeowner.
When choosing the right type of renovation financing, keep these tips in mind. Remember that the right type loan for you will depend on your situation and the project you’re planning.
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