A home equity loan or HELOC, can be a way to fund home improvement projects such as a kitchen remodel, opening up rooms in an open concept, finishing a basement, or doing a bath remodel. These can be quite expensive, especially when part of the project includes new kitchen appliances, flooring and furniture, or replacing plumbing. Major home improvements can easily balloon the costs into tens of thousands of dollars, greatly exceeding cash on hand.
Of course, leveraging your home’s equity doesn’t come without risk. That’s why you should use the money sparingly because you don’t want to find yourself in a situation where you’ve made significant improvements which up the value of your house and then have difficulty paying the money back. Another thing to avoid is making improvements which cause your home to be priced out of the neighborhood because you’ll have a lot of difficulty to sell it in the future.
Five Misconceptions about a HELOC
Though a home equity line of credit is a debt instrument, many homeowners misunderstand how these actually work. A big time myth about a HELOC is that it’s a second mortgage even though there are closing costs involved in obtaining the money. Another myth is that your lender won’t lower the amount you qualify for because that can and does happen. If you home’s value decreases or your credit score drops, your lender can decrease the limit.
“With a home equity line of credit (HELOC), you’re approved for a total loan amount, but bank does not give you money in a lump sum. Instead, you get a credit/debit card, or a checkbook (or both) and you withdraw money when needed. You only pay interest on the amount you’ve taken out, and you’re only limited by the total amount of the loan. Up to $100,000 of the loan is tax deductible.” —Wall Street Journal
Some homeowners believe that a HELOC is a type of cash reserve, but it isn’t because you will be given a limited amount of time to withdraw funds and you won’t be able to pull out the full amount of equity that’s built-up in your home. You’ll probably be able to access up to 70 percent, even up to 85 percent, but the less you do the less risk you incur. Yet another myth is that home equity lines of credit will always be less expensive than a home equity loan. A HELOC will not only have closing costs, but also an annual fee and a cancellation fee; and, some lenders will hit you with a prepayment penalty if you pay the loan off early. You might be required to make several withdrawals per year and you could face a fee that’s thousands of dollar if you decide that you no longer want the HELOC.
What to Know about Using a Home Improvement HELOC
If you do obtain a home equity line of credit, you ought to be smart about using the funds you withdraw wisely. The first thing you should do is identify what the project will entail and evaluate whether or not it’s worth the investment. Some home improvements have a low return on investment and those include such things as home office remodel, which only bring 48.9 percent back, adding a sunroom or master bedroom suite addition, and installing another bathroom, which has an ROI of 60 percent.
When you have pinpointed the scope of the project, then get at least three quotes from licensed contractors. Do a little research on each, checking insurance, licensing, past projects, and searching the local clerk of court’s office for lawsuits against them by other homeowners. You should also check references and ask to see current projects they are working on. Also, ask who will actually be doing the work because it isn’t unusual for a contractor to bring in subcontractors for a job.
After you’ve decided on the contractor, you should talk opening about the remodeling contract. You should be prepared to spend 10 to 15 percent more than the estimate because contingencies are quite common. Set aside ten to fifteen percent for unplanned expenses to keep your budget from bursting at the seams. Materials aren’t typically the big cost items, it’s the labor that really adds up. So, if you’re able, do what you can on your own and save some money while gaining a little personal pride in your project.