A home equity loan can provide you with the funds you need for home improvements. If you’ve already built equity in your home, you can tap into it to access the funds.

So, how does a home equity loan work for home improvements? You can prequalify with a lender to check the rates you qualify for. Depending on the project, the interest you pay on the loan may also be tax-deductible.

It’s important to understand how these loans work, how to qualify, and weigh the pros and cons before you use your home equity to fund renovations.

How Does a Home Equity Loan Work for Home Improvements?

So, how does a home equity loan work for home improvements? You can tap into the equity of your home and get a lump-sum amount from the lender. You can use the funds for home improvement projects, renovations, and repairs.

Home equity loans are secured loans because your home serves as collateral. This allows you to borrow funds at a lower interest rate but also comes with risks since the lender can foreclose if you default on the loan.

Just like mortgage loans, you’ll pay back the amount you borrow with interest through monthly installments. Home equity loans are also called second mortgages since you’ll have a second payment each month in addition to your mortgage payment.

Example of How a Home Equity Loan Works

Home equity is the difference between the value of your home and what you owe on your existing mortgage.

For example, if your home is worth $500,000 and your mortgage balance is $300,000, your home equity is $500,000 - $300,000 = $200,000.

Your lender will decide how much you can borrow against your equity. For example, you may be able to borrow up to 85% of the available equity with a home equity loan.

$200,000 X 0.85 (85%) = $170,000

In this example, you can potentially get a home equity loan of up to $170,000 for home improvements.

Pros and Cons of Using a Home Equity Loan for Home Improvements

Like any other loan, there are benefits and drawbacks to using a home equity loan for home improvements.

Pros

  • Home equity loans have lower interest rates compared to other options like personal loans.
  • These loans have fixed interest rates, so your monthly payments will remain the same throughout the term.
  • You can use the funds from the loan for any purpose, including home renovations and improvements.
  • These loans have a longer repayment term of up to 30 years, so the monthly installments can be lower.
  • The interest you pay on the loan can be tax-deductible if you use the funds to buy, build, or substantially improve your home.

Cons

  • Your home is at risk of foreclosure if you don’t repay the loan as agreed.
  • Home equity loan rates can be higher compared to HELOCs in many cases.
  • You may not be able to borrow a larger amount if you don’t have enough equity.
  • You may have to pay 2% to 5% in closing costs.
  • Unlike unsecured home improvement loans, home equity loans can take longer to fund.
  • You may pay more in interest over the life of the loan with a longer term.

How To Qualify for a Home Equity Loan for Home Improvements

Eligibility criteria for home equity loans can vary by lender, but you’ll generally have to meet these requirements:

  • Credit Score: Most lenders require a credit score of at least 620. However, credit score requirements vary by lender, and you may be able to qualify for a bad credit home equity loan with a lower score. However, you may pay a high interest rate for these loans.
  • Debt-to-Income Ratio: Lenders will usually require a maximum debt-to-income (DTI) ratio of 43%. However, if your other financials are strong, some lenders may allow up to 50%.
  • Home Equity: Lenders usually approve a maximum loan-to-value ratio (LTV) of 80% to 85%. This means that you must have at least 15% to 20% equity in your home.

How To Get a Home Equity Loan for Home Renovations

Before you get a home equity loan, it's important to consider a few things, such as:

  • Interest rate
  • Closing costs, origination fees, and other fees
  • Lender’s reviews
  • Repayment terms
  • Loan amounts
  • Eligibility requirements

Once you’ve considered these factors and decided to apply for a home equity loan, these are the steps you’ll need to follow:

  1. Gather important documents you’ll need during the application process, such as your W-2 forms, tax returns, bank account statements, pay stubs, and government-issued ID.
  2. Shop around and compare the rates and terms offered by different lenders to find the lowest rates.
  3. Prequalify to get a better understanding of the rates you qualify for.
  4. Fill out the loan application and submit it with the documents.
  5. Once your loan is approved, you’ll work with the lender to set a closing date.
  6. Pay the closing costs and receive the loan funds.

Alternatives to Home Equity Loans

If a home equity loan is not right for you, there are several other types of loans to consider to fund home improvement projects:

  • HELOCs: A home equity line of credit or HELOC is a revolving line of credit against the equity of your home. You can borrow as much as you need, when you need it, up to your approved credit limit during the draw period. HELOCs have a variable interest rate, and you’ll make interest-only payments during the draw period.
  • Home Equity Sharing Agreements: In exchange for a percentage of your home's future value, some investment companies offer upfront cash that you can use for home improvements. A home equity sharing agreement doesn’t require monthly payments or interest, but you’ll share a portion of your home's appreciation when you sell.
  • Personal Loans: Personal loans are easier to qualify for and quicker to fund. While you’ll pay a higher interest rate compared to home equity loans, you don’t risk losing your home since these are unsecured loans.
  • Credit Cards: If you have good credit and qualify for a credit card with a 0% APR promotional offer, it may be a good idea to use the card to fund your home renovation. Keep in mind that you’ll need to pay off the entire balance before this promotional offer ends to avoid paying interest on it.
  • Cash-Out Refinance: You can replace your current mortgage with a new, larger mortgage and cash out the difference to fund your home improvement project. This option is best if you can qualify for a lower mortgage rate than what you’re currently paying.

Should You Use a Home Equity Loan for Home Improvements?

A home equity loan offers some important benefits, like low interest rates and longer repayment periods, so it can be a good way to pay for home remodeling and improvements. In some cases, you may be able to increase the value of your home and deduct the interest on the loan.

Before applying for the loan, weigh the pros and cons, check if you’re eligible, compare your loan options, and consider other alternatives to see if they fit your financial needs better.