June 2022
Tapping home equity is a popular option of many ways to fund home improvements. Borrowers cite the benefits of lower interest rates associated with secured debt and the tax-deductibility of loan interest. Lenders favor home equity loans as they carry lower risk.
Home equity is the difference between the value of your property and the remaining mortgage debt. It is a valuable asset that can be used to upgrade to another home or used in retirement years. Tapping into equity depletes it, and you risk losing your home in the event of default. This resource should only be used when a return is certain.
If you plan to use your home equity to fund a home improvement project, you can do so with a cash-out refinancing or home equity loan.
Refinancing refers to the process of replacing an existing mortgage with a new one, usually on more favorable terms. In a "cash-out" refinancing, the replacement mortgage exceeds the value of the currently outstanding mortgage balance. Once the existing mortgage is settled, the borrower can "cash out" the difference to meet the cost of home improvements. Refinancing involves closing costs. Therefore, the borrower has to compare the benefits by way of better loan terms and value addition to the home against the costs involved in arranging and servicing a bigger loan.
A home equity loan can be a fixed loan or a line of credit with a set limit that can be drawn down as and when required. It is typically a second mortgage over the home. Provided the primary mortgage holder has no objection to taking out a second mortgage, this option allows the homeowner to get funding for a specific project without altering the terms of the first mortgage. A term on a home equity loan is usually around 15-20 years, although shorter or longer terms are possible. A Home Equity Line of Credit (HELOC) has a variable interest rate that is linked to the prime rate.
Lenders usually provide refinancing or a second mortgage so that the value of the new first mortgage (if refinancing) or combined mortgages does not exceed 75-80% of the property's current value. Although some lenders provide home equity loans exceeding this limit, a borrower should be aware of the risks involved in getting such funds.
Many factors depend on deciding between a "cash-out" refinancing and a home equity loan. If opting for a home equity loan (second mortgage), the combined costs of servicing both the first and second loans should be less than arranging for and servicing a "cash-out" refinancing. This usually means making higher loan payments until the home equity loan is paid off. A cash-out refinancing would involve lower payments spread throughout a longer term.
To ensure that you complete your home improvement project and enjoy its benefits without regrets, here are four considerations that will help you decide whether you should choose a cash-out refinancing or a home equity loan.
- What is the cost and timing of the home improvement project?
The cost of your project can be based on estimates provided by contractors/suppliers and by adding a margin of around 15% to cover contingencies. If the project is to be phased out over time, a line of credit can be a better option than refinancing. The loan size may favor taking out a home equity loan rather than arranging for refinancing.
- How long do you plan to stay in your home?
Embarking on a home improvement project involves time and money not only for the planned outlay but also for appraisals, credit checks, application fees, and payment of points in arranging loan funds. These investments can make sense only if you remain in your home long enough to recoup such investments. If you opt for a home equity loan to spruce up your home before selling, a second mortgage that can be settled upon the sale of your property may be a better option. Knowing the pay-back period for your loan is therefore essential. - Is the cost affordable?
A home-improvement project should only be undertaken if mortgage payments are affordable, considering your overall financial obligations. Lenders usually check that your total debt as a percentage of income does not exceed 36%, providing a contingency fund of around three months' expenses to cover unexpected events such as job loss or illness.
Such factors would determine your overall costs in terms of interest and points to lenders as your credit score, income earned, and employment stability. While a credit score above 640 would be acceptable to most lenders, those with a lower score would be quoted higher rates to offset perceived risks. If a lower score arose from an extraordinary situation, explaining such a circumstance to your lender would help you get a more favorable term.
Private mortgage insurance is an additional expense to a borrower when the mortgage debt exceeds 80% of the home's appraised value. If you are currently paying mortgage insurance or a "cash-out" refinancing moves you beyond this threshold, refinancing may not be a good choice at this time. - Tax considerations
Interest on home equity loans up to $100,000 can be claimed for tax purposes provided costs are itemized and the loan is secured against the house's value. However, the amount that can be claimed could be restricted by the remaining balance on your first mortgage. In short, consult your tax advisor. Deductibility of mortgage interest may vary depending on your individual tax situation and the purpose of loan funds.
Online mortgage calculators provided by First Federal can also help check out different options when deciding between a "cash-out" refinancing and a home equity loan. Obtain quotes from at least three brokers or lenders, including your existing lender, to ensure that you have the best terms to suit your situation. To speak with someone on the First Federal Lending Team, visit our website to get started.
Following these guidelines will enable you to use your home's equity wisely to complete your home improvement project.
