How Does a Home Equity Loan Work for Home Improvements?

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The cost of home renovations can be overwhelming if you use spare cash to pay for the work. A better solution for some homeowners is to finance the work with a home equity loan.

Introduction to Home Equity Loans

Home equity is the portion of your home’s value that you own free and clear.

Equity accumulates over time as you pay down your mortgage loan. The longer you pay down the loan, the faster equity accumulates because more and more of your payment goes toward the principal rather than interest.

You also gain equity when your home appreciates.

Understanding Home Equity Loans

A home equity loan is a one-time lump-sum loan against your equity that you pay back in monthly payments, usually over 10 to 30 years. Rates are typically fixed, so your payment never changes. You can use the loan to finance major expenses like home improvements.

Your home serves as collateral for the home equity loan, which means you can lose your home if you default on the loan. Other financing options exist that don’t carry this risk.

A personal loan is one. Personal loans usually don’t require collateral, and you may qualify for as much as $200,000, depending on the lender and your creditworthiness.

You can also use credit cards to pay for the work. This is a dangerous choice because of the high rates on most cards. However, you might consider it if you have a card with a 0% introductory rate and have a smaller project you can pay off before the promotional rate expires.

Benefits of a Home Equity Loan for Home Improvements

Using a home equity loan for home improvements makes sense for several reasons.

Financial Advantages

Home equity loan interest rates are usually lower than rates on personal loans and credit cards. The most recent data from the Federal Reserve shows that credit card rates are averaging nearly 23% interest and 24-month personal loans are averaging 12.27%. However, it’s not unusual to find home equity loans charging highly qualified borrowers less than 7% annual percentage rates.

Another benefit is the possibility of writing off the interest you pay on the loan. If you itemize tax deductions and you use the loan proceeds to substantially improve the home secured by the loan, you can deduct first- and second-mortgage interest on up to $750,000 worth of debt.

Enhancing Home Value

Some remodeling jobs produce positive returns on your investment. For example, The Journal of Light Construction lists the following jobs as good financial investments:

• Garage door replacement: 193.9% return on investment
• Entry door replacement (steel): 188.1% return
• Manufactured stone veneer: 153.2% return

The next best investments, a grand entrance made of fiberglass and a minor kitchen remodel, have slightly lower returns, at 97.4% and 96.1%, respectively.

That said, if your home is in poor condition compared to similar homes in your neighborhood and the value has suffered as a result, improvements that bring your home up to your neighborhood’s standard will also increase its value.

How Home Equity Loans Work

A home equity loan works similarly to a regular mortgage loan.

Loan Application Process

You can apply for a loan online, on the lender’s website, by phone or in person. Have the following documents ready when you apply:

• Most recent 30 days’ worth of paystubs
• Most recent two years of W-2 forms
• If self-employed, two most recently filed federal income tax returns, including Schedule Cs
• Proof of any additional sources of income, such as pensions, government benefits and investments
• Proof of homeowners insurance

Determining Loan Amounts

Lenders typically allow you to borrow up to 80% or 85% of your equity — in other words, they allow a maximum loan-to-value ratio of 80% to 85%, inclusive of all mortgage loans. Remember, you’ll need to know your home’s value to determine how much equity you have. Searching Zillow or Realtor.com for recent sale prices of similar homes in your neighborhood can give you a rough idea of your home’s value. Your lender will order an appraisal for a more precise valuation.

Repayment Terms

Home equity loans usually have fixed rates, so your interest rate and payment amount stay the same over the entire loan term. Available terms vary by lender but can range from five or 10 years to 30 years.

Eligibility Criteria for Home Equity Loans

Each lender sets its own loan requirements, but the requirements are fairly consistent from one to the next.

Assessing Your Home’s Equity

The lender will order its own appraisal to determine your home’s market value and calculate how much equity you have available to borrow.

Credit Score and Financial Standing

Credit score requirements range from 620 to 660, depending on the lender.

You’ll also need enough income to afford the payments. Lenders typically allow a maximum debt-to-income ratio of 43% to 50%, inclusive of all debt payments and mandatory home costs like homeowners insurance, property tax and homeowners association fees.

Risks and Considerations

Consider the potential downsides you might encounter if you take out a home equity loan for a remodel.

Potential Pitfalls

The major drawback of a home equity loan is that your home secures the loan. That means you can lose your home to foreclosure if you default on the loan.

Another downside is cost. Even though rates are lower than for credit cards and personal loans, the loans are long-term, so the interest adds up.

Did You Know?

Home equity loans have closing costs and other fees. Those that claim to have no closing costs simply build those costs into a higher interest rate — and might require you to reimburse the lender out of pocket if you pay the loan off early.

Market Fluctuations

Home values fluctuate as local real estate markets move up and down. That means a steep decline in value can leave you owing more on your loans than your home is worth. If that happens, you won’t be able to sell your home if an extended financial emergency leaves you unable to make the payments. That may make it more difficult to sell your home or stay on top of the payments, thus increasing the risk of foreclosure.

You can offset that risk by borrowing only the amount of equity you need and maintaining enough emergency savings to carry you over for at least a few months.

Alternatives to Home Equity Loans

A home equity loan for home improvements is just one way to tap into your equity for home improvements. The others are a home equity line of credit and cash-out refinance.

Home Equity Line of Credit

A home equity line of credit is a revolving credit line secured by your home. It’s similar to a credit card in that you can pay down the balance and then reuse the credit up to your credit limit. You can only access the credit line during the loan’s draw period, which usually lasts 10 years. After that, you typically have 20 years to pay off the loan. HELOCs usually have a variable rate that changes periodically, but many lenders allow you to change part of your outstanding balance to a fixed rate.

HELOC Benefits

The benefit of a HELOC is that you can borrow only what you need, as you need it, which makes this a good choice for ongoing improvement projects. Also, you can make interest-only payments during the draw period. You’ll have to pay closing costs, though, or a higher rate in the case of a loan with no out-of-pocket closing costs. The variable rate can result in higher payments and higher overall loan costs than you bargained for.

Cash-Out Refinance

A cash-out refinance also lets you tap into equity, but it does that by replacing your current mortgage loan with a new first mortgage. The refinance loan pays off your existing mortgage and pays out the equity to you, up to the loan’s limit, in cash.

This can be a good option if your new loan has a lower rate than your existing mortgage. However, those savings will be offset by extending your repayment period. The longer you’ve been paying on your existing loan, the bigger hit you’ll take. What’s more, you’ll likely have to pay mortgage insurance if the new loan has an LTV of more than 80%.

On the upside, rates for cash-out refis are often lower than rates on home equity loans and lines of credit.

Steps To Take Before Applying

Some preparation will help your application and loan process go more smoothly.

Evaluate Your Financial Situation

Before applying for any major loan, it’s a good idea to check your credit report to make sure there are no errors or oversights that could keep you from being approved.

Next, use an online home equity loan calculator to estimate how much your payments might be. Use that information to calculate your debt-to-income ratio — divide the total of your housing and other debt payments, including the new loan payment, by your monthly income. A DTI of 50% or less suggests you have enough income for the home equity loan.

Research and Compare Lenders

Rates and loan offerings can vary widely from one lender to another. Research lenders and loans online and then request rate quotes from your two or three top picks. Also, look at origination and other fees as well as available loan terms.

Information is accurate as of March 13, 2025.

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