Should you get a HELOC for home improvement?

What is a HELOC for home improvements? 

A HELOC is a revolving line of credit, usually with a variable interest rate, that lets you finance home upgrades as you go. You may be able to borrow against a percentage of the available equity in your property whenever you like during your draw period, which is usually up to 10 years. 

To estimate your available equity, subtract what you owe on your mortgage from your home's current market value. For example, if your house is worth $500,000, and you have $300,000 left on your mortgage(s), your home equity should be $200,000. 

A lender might let you borrow a portion of your equity based on your loan-to-value (LTV) ratio and other factors. LTV measures the amount you owe on your mortgage compared to your home's appraised value, expressed as a percentage. So if a lender allows an LTV of 80%, you would calculate your borrowing potential as follows:

• Multiply your home’s market value by the LTV ratio: $500,000 x 80%= $400,000
• Subtract your current mortgage balance from this amount: $400,000-$300,000= $100,000
• You would have up to $100,000 available in equity to borrow.

Pros and cons of funding home improvements with a HELOC

HELOCs have several advantages and disadvantages:

Pros

• Lower interest rates: Annual percentage rates (APRs) for HELOCs tend to be lower than some other financing types, including credit cards and home improvement loans.
• Flexibility: Other kinds of credit, such as home equity loans, give you a lump sum you must pay back with interest even if you don't use all the money. With a HELOC, you can borrow cash as needed up to a certain limit during your draw period. This might provide more flexibility, especially if you don’t know how much a home improvement project will cost.
• Possible return on investment: A HELOC can fund home improvements that potentially increase the resale value of your property. For example, adding a bedroom or bathroom to your house could provide a substantial return on investment.
• Tax benefits: The IRS says you may be able to deduct the interest you pay on a HELOC from your tax return if you use the funds to "substantially improve" your main or second home. There are limitations on how much you can claim and other restrictions, so you may want to consult a tax advisor.

Cons

• Variable interest rate: The interest you pay on a HELOC for home improvement is usually variable, meaning it can increase based on economic conditions and other factors. The unpredictability of variable interest might make it difficult to budget for repayment. That said, some lenders may let you convert all or part of your HELOC into a fixed-rate loan (usually at closing or during the draw period), which could help you plan for a more predictable repayment.
• Increase in payments: During your draw period, you can make interest-only payments on the amount you borrow. After this period ends and the repayment period begins, you’ll need to repay the principal balance and interest, and your monthly payments will likely increase. This period usually lasts for a set amount of time, typically up to 20 years. 
• Your home is at risk: HELOCs are secured by your home, so you risk foreclosure if you can’t make payments.
• Closing costs: When applying for a HELOC, consider that you might have to pay closing costs. These costs may include an application fee, origination fee, appraisal fee, title search, and other expenses. However, not every lender charges all these fees, and you may be able to roll these extra costs into your balance instead of paying them upfront.

Questions to ask yourself before getting a HELOC

Think about the following before applying for a HELOC:

• Do you have enough equity in your home? Most lenders require you to have at least 10% to 20% in home equity for a HELOC. You might already meet this condition if you've been paying your mortgage for a while or made a sizeable down payment. If not, think about alternative financing sources or extend your home improvement plans. For example, savings and credit cards may fund smaller projects until you build enough equity to borrow against. 
• Can you afford repayments? During your draw period, you'll need to make monthly interest payments to your lender based on how much you borrow. Because interest rates on a HELOC are often variable, the amount you pay might increase in the future. Consider whether your budget allows for this. You must also pay back your principal balance plus interest after the draw period ends. 
• Are you eligible for a HELOC? Lenders consider multiple factors before approving you for a HELOC, including your credit score, income, LTV ratio, and debt-to-income (DTI) ratio. It can be helpful to find out whether you’re preapproved and what your terms might be before applying.

How to get a HELOC for home improvement

Here's what the process usually involves:

Find the right lender

Many lenders offer HELOCs, so shop around for the best interest rates and terms. Also, compare fees you might have to pay during closing.

Complete your application

Once you've found a lender, it's time to fill out your application. You'll normally provide information about your financial situation, including income, expenses, and debts. Gather relevant documentation, such as tax returns, pay stubs, and W-2 forms.

Prepare for a home appraisal

Your lender may request an appraisal. This ensures your home is worth enough to cover your HELOC amount. Usually, an appraiser visits your house and assesses its condition, size, location, and other factors before reporting their findings to you and your lender. 

Preparing your home could increase its appraisal value, so consider cleaning up your space, making minor repairs, and investing in small upgrades.

Go through underwriting

If your appraisal value equals or exceeds the HELOC amount you applied for, your lender may start the underwriting process, which involves verifying your income, assets, and other financials.

Access funds for home improvement

After your lender completes underwriting, they may approve your HELOC. You can then use funds to finance a restoration, renovation, or other home improvement project.