Is a Home Equity Loan a Good Idea? Here's What We Know

Whether a home equity loan is ideal depends on several factors, including your financial health and your goals for the future. Considering all of them and asking yourself important questions are vital for deciding what’s right for you. You can use the resources available on RenoFi’s website to help you determine what’s best. 

Home Equity Loan Uses

Many people use a home equity loan to complete home improvement projects that could potentially add value to their property. Some of the best home improvement projects you may want to consider include:

• Adding an Accessory Dwelling Unit (ADU)
• Adding a garage
• Remodeling the kitchen
• Remodeling the bathroom
• Adding another bathroom
• Adding a second-floor
• Finishing a basement
• Replacing your roof
• Adding an inground pool
• Replacing old flooring
• Installing a deck 

If you want to use a home equity loan to make home improvements, it’s a good idea to speak with your accountant about how certain home projects and their respective costs can impact your tax returns. The improvements may be tax deductible. 

Although many homeowners use a home equity loan for home improvement projects, there are several additional ways to use it, including:

• Unexpected medical bills
• A wedding
• A vacation
• Starting a business
• Replacing a vehicle
• Paying down debt
• Attending school

Applying for a Home Equity Loan With Co-Signer

Some homeowners feel comfortable adding a co-signer, while others prefer to wait until they can shoulder the responsibility of the home equity loan on their own. The decision depends on your preference. 

It’s a big (added) responsibility to do so because you’re also putting their credit score at risk, and they share the legal obligation with you for the loan. There could also be potential personal conflicts in the future, depending on the situation—for example, if you find yourself unable to make the payments or if they want to withdraw from the home equity loan.

Credit Card vs Home Equity Loan for Expenses

Multiple factors are involved to determine which is the better option for you. For example:

• Amount of home equity vs. usable credit card balance
• Credit card and home equity loan interest rates
• What you want to use the money for
• New credit card monthly payments vs. amount of monthly home equity loan payments
• If you qualify for a home equity loan

Take time to weigh the pros and cons and consider which is the best solution for your situation. 

Documentation for a Home Equity Loan Application

Financial institutions don’t give out home equity loans easily, which means providing a substantial amount of personal information to prove that you can make your payments on time. Some of the documentation includes:

• Proof of primary source of income 
• Evidence of additional sources of income 
• Social security number
• Proof of a residential address
• Tax returns
• Bank statements

That’s only some of the documentation you’ll be required to provide. If you are unable or unwilling to provide the required information, a home equity loan may not be the best option for you.

The Pros and Cons of a Home Equity Loan

Preparing to make a major financial decision, such as applying for a home equity loan, involves weighing the pros and cons to determine what is likely to produce the best outcome. 

Some of the pros of getting a home equity loan are:

• Lengthy repayment terms
• Monthly payments that don’t change
• An interest rate that typically doesn’t change
• Ability to apply with a “fair” credit score
• Interest rates that are generally lower than a credit card
• Ability to apply with a co-signer 

Several of the cons of a home equity loan are:

• Risk of going into foreclosure
• The amount of available home equity may not be enough to cover your needs
• You may not qualify for the amount you need
• Getting the money could take weeks
• Increases your amount of debt
• It can initially lower your credit score

Why a Home Equity Loan Might Not Be Ideal

While a home equity loan can be used to fund valuable renovations, it’s important to weigh out the pros and cons we have outlined above and consider your current financial situation before applying. Here are some of the risks you may encounter with a home equity loan. 

Failure to Make Payments on a Home Equity Loan

When you take on a home equity loan, you’re agreeing to a second mortgage. This means making two separate mortgage payments each month instead of just one. If you can’t make the payments, your home faces foreclosure. It’s one of the most important reasons you should plan accordingly and only apply for a home equity loan if you’re certain that you can make the agreed-upon monthly payments. 

Increased Debt Burden

When you take on a home equity loan, you are adding to your debt burden. So, if your financial situation changes or if other unexpected expenses arise, you may find it more difficult to manage multiple debts.

Market Fluctuations

If there is a decline in the housing market, the value of your home may start to drop– which can ultimately leave you owing more on your loan than your home is actually worth. This is known as negative equity.

High Closing Costs

A home equity loan comes with closing costs and fees. These fees can begin to add up, ultimately reducing the financial benefits. 

When You Should Avoid a Home Equity Loan

Here are some instances you may want to consider avoiding a home equity loan. 

• Unstable Financial Situation: Inconsistent income or if you are experiencing financial hardship.
• High Debt-to-Income Ratio: If your current DTI is already high, a home equity loan can further strain your finances and make it hard to meet your monthly obligations.
• Low Home Equity: If your home lacks equity due to market conditions or recent purchases, borrowing against it might not leave you with sufficient funds for your needs.
• Planning to Move Soon: If you plan to sell your home soon, a home equity loan will not be as beneficial for your situation.
• Planning on Significant Renovations: If you are planning on significant renovations and may require more funds than initially anticipated, a home equity loan might not provide you with the financial flexibility required to cover unexpected costs.

Why RenoFi Loans Are a Good Option

Another option you have is with RenoFi. Let’s imagine you want to spend $150,000 to renovate your new home and increase the value of your home:

Scenario 1 (New Home Purchase): 

• Home price: $600,000
• Downpayment (20%): $120,000
• Current Mortgage Amount: $480,000

Example Home Equity Loan Amount: 

• $600,000 * 80% = $480,000 (80% of Total Home Value)
• $480,000 - $480,000 (Current Mortgage Balance) = $0 (Home Equity Loan Amount)

Example RenoFi Home Equity Loan Amount:

• Assuming that your renovation project will add $150,000 to your home value

• After Renovation Value of Your Home: $750,000

• RenoFi Loan Amount: 

  • $750,000 * 90% = $675,000 (90% of Total Home Value)
  • $675,000 - $480,000 = $195,000 (RenoFi Home Equity Loan Amount)

Using a RenoFi Home Equity Loan you have increased your loan amount from $0 to $195,000. Not only are you now able to borrow the $150,000 you wanted to renovate your home, but you can now borrow up to $195,000 because the RenoFi loan is written against your ARV (After Renovation Value).

Without RenoFi loans, you would not have been able to borrow the $150,000 needed to add the renovations that would increase the value of your home by $150,000. Now, with RenoFi loans, you are now able to get the loan you need to add the renovations you want to your home.

Scenario 2 (Recent Home Purchase): Assuming that you have now paid 10% of your mortgage:

• Home price: $600,000
• Current Mortgage Amount: $420,000

Example Home Equity Loan Amount: 

• Example Home Equity Loan % of Home Price: 80%

• Example Home Equity Loan Amount: 

  • $600,000 * 80% = $480,000 (80% of Total Home Value)
  • $480,000 - $420,000 (Current Mortgage Balance) = $60,000 (Home Equity Loan Amount)

Example RenoFi Home Equity Loan Amount:

• Assuming that your renovation project will add $150,000 to your home value

• After Renovation Value of Your Home: $750,000

• RenoFi Loan Amount: 

  • $750,000 * 90% = $675,000 (90% of Total Home Value)
  • $675,000 - $420,000 = $255,000 (RenoFi Home Equity Loan Amount)

Using a RenoFi Home Equity Loan you have increased your loan amount from $60,000 to $255,000 (4.25x more). Not only are you now able to borrow the $150,000 you wanted to renovate your home, but you can now borrow up to $255,000 because the RenoFi loan is written against your ARV (After Renovation Value). 

Here’s a summary of the difference between traditional and RenoFi home loans in table form: 

In addition to letting you borrow more money for your home renovations, RenoFi loans also offer:

• No draw periods
• No inspections
• No need to give up your original loan
• Higher borrowing limits

RenoFi loans are funded on the day the loan is closed and that is it. Take out the $195k and you get $195k in your bank and you have 20 years to pay off in equal monthly payments with interest and principal, just like a standard mortgage.

Conclusion

The RenoFi website has an extensive resources section with information about home equity loans, including what home equity is and how it works. 

Additionally, RenoFi loans are the smartest way to finance a home renovation project. Unlike traditional loans, which are based on your current home value or require you to refinance your primary mortgage and give up your low rate, RenoFi loans are based on the after-renovation value of your home. This allows you to borrow, on average, 11x more, get a low monthly payment, and keep your low rate on your first mortgage. 

Explore your RenoFi loan options here.