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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 of the reasons that they are popular for home improvement projects is because 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 the HELOC 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 consider 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. Contact a financial advisor or Rocket Lawyer network attorney for assistance with determining which type of financing method is best for your specific situation. 

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 taxes. To deduct this mortgage interest, the loan funds are required to have been used to buy, build, or improve a qualifying home. Furthermore, to be eligible for the deduction, the home that secures the home equity loan or HELOC is required to be the home where the funds are used, and that home is required to be a qualifying residence, such as your primary or vacation home. Additionally, you are required to itemize deductions on your tax return to claim the mortgage deduction for your home equity loan or HELOC. 

For purposes of deducting the mortgage interest, there are limits as to the size of the loan that is fully deductible. Generally, if the loan was obtained after 2018 then only the interest on the first $750,000 is deductible. For loans obtained before 2018, interest is usually only deductible on the first $1,000,000 of borrowed funds. The debt also cannot exceed the qualifying home’s value. For example, if the qualifying home is worth $200,000, but your home equity loan is $300,000, only the interest on the first $200,000 may be deductible. Closing costs for your home equity loan or HELOC are generally only deductible if they are payments toward mortgage interest or property taxes.

It can be tricky to determine if your mortgage interest payments qualify for a tax deduction when you have a home equity loan or HELOC. For assistance determining if, or how much of, your mortgage interest payments you can deduct on your tax return, contact a tax professional.

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 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 is difficult to know how much value the improvement adds to your home’s value. If you have questions about your property taxes, or the home equity loan process, reach out to a Rocket Lawyer network attorney for affordable legal advice. 

This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.

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