How do home equity loans work?
A home equity loan or line of credit allows you to use your home equity as collateral to receive a lump sum cash payment or a line of credit. By using your home as collateral, you are able to obtain a larger loan and a lower interest rate than you would likely be able to obtain if the loan was not secured by collateral because the loan is less risky for the lender.
A home equity loan or home equity line of credit (often called a HELOC) can generally be used for anything, although they are commonly used for remodeling or home improvement projects. One reason they are popular for home improvement projects is that they allow a greater amount of borrowing than is generally available on credit cards or personal loans. They also usually have more favorable terms and interest rates than other financing options.
Like any other financing that is secured by your home, there are risks to consider before applying for a home equity loan or HELOC. The main risk is that your home may face foreclosure if you are unable to make the payments on the loan.
What is the difference between a home equity line of credit and a home equity loan?
A HELOC is a line of credit that is secured by your home. Unlike a traditional mortgage, a HELOC gives you a revolving credit line. That means that you can draw on the line of credit, pay it back, and then draw on it again. Essentially, a HELOC is similar to having a credit card that is secured by your home. A HELOC typically carries a lower interest rate than other lines of credit because it is secured by your home and is therefore less risky for the lender. However, it is generally a variable rate, meaning it can change occasionally. A HELOC can be a good option when homeowners are considering selling their home but want to make improvements to increase the value first.
A home equity loan lets you exchange some of the equity in your home for cash. It uses your home as collateral. With a home equity loan, you receive the loan amount in a lump sum at the closing of the loan, as opposed to a revolving line of credit. Typically, a home equity loan has a fixed interest rate, which is in contrast to the variable interest rate commonly attached to a HELOC. Another key difference is that you pay interest on the full outstanding balance of a home equity loan, whereas you only pay interest on the funds that you have drawn from the line of credit with a HELOC.
If you are considering a HELOC or home equity loan for financing a home improvement project, the type of project might dictate which type of financing is best for your situation. If the project requires a large lump sum payment upfront, then a home equity loan might be the best option. However, if the project is occurring over a long period of time and expected to require frequent, smaller payments, a HELOC may be a better financial product. Consider consulting a financial advisor or a Legal Pro to determine which financing method best fits your needs.
How does a home equity loan impact taxes?
You may be able to deduct the mortgage interest from your home equity loan or HELOC on your federal tax return. To deduct this mortgage interest, the loan funds must be used to buy, build, or substantially improve a qualifying home. Additionally, the home that secures the home equity loan or HELOC must be the same home where the funds are used, and that home must be a qualifying residence, such as your primary or secondary home. You are also required to itemize deductions on your tax return to claim the mortgage interest deduction.
For purposes of deducting mortgage interest, there are limits on how much home mortgage debt qualifies for the deduction. These limits can change over time, so check the IRS page on home mortgage interest deductions for current details.
Closing costs for your home equity loan or HELOC are generally only deductible if they are payments toward mortgage interest or property taxes.
Because the rules can be complex and subject to change, it’s a good idea to review the most recent IRS guidance or speak with a qualified tax professional if you’re unsure whether your interest payments qualify.
Is it likely for my property taxes to increase after remodeling using a home equity loan?
Any type of remodeling may cause your property taxes to increase, regardless of whether a home equity loan or HELOC is used or not. Below are some types of renovations that are likely to increase your property taxes:
- Constructing home additions.
- Building a deck or outdoor recreation area.
- Adding an in-ground pool.
- Making structural changes to the home.
- Finishing a basement.
It is not uncommon for assessors to receive information regarding construction and remodeling permits, and assessors may use that information to adjust your home’s assessed value. Additionally, assessors periodically visit properties or use satellite images to determine if improvements have been made to a property.
The amount that an improvement might change your property taxes is hard to determine because it depends on how much value the improvement adds to your home. If you have questions about your property taxes, or the home equity loan process, reach out to a Legal Pro for affordable legal advice.
Please note: This page offers general legal information, not but not legal advice tailored for your specific legal situation. Rocket Lawyer Incorporated isn't a law firm or a substitute for one. For further information on this topic, you can Ask a Legal Pro.
