Many people think about home ownership in phases—the starter house, an upgrade or two, and the elusive “dream home.”
What does your dream home look like? Does it have an HGTV-level kitchen, a spa-like main bathroom, or a swoon-worthy patio?
While you may think that house sits on top of a hill, what if the forever-home potential is in your current four walls?
You might not have to move to make your dream house a reality! If you like your area, have built a close community, and see yourself staying, then why uproot your life when a few fixes could make your home work for you?
Now that you’re excited to stay put, how can you pay for the changes you want?
Yes, significant home remodels can be expensive, but there’s a tool you can pull out of your back pocket: tapping your home’s equity via a home equity line of credit (HELOC).
- What’s a HELOC?
- How does it work?
- Are there downsides to consider?
- Can it help you make your dream home?
Let’s find out!
First, Put A Price Tag On The Dream Home
Before bringing banks and loans into the mix, you must know how much your dream home will cost. While every job is different depending on your area and aspirations, here are some national figures to consider.
A 2022 Houzz & Home survey uncovered that homeowners who plan on high-budget renos plan to spend $75,000 on their projects.
If you’re planning on altering the structure/foundation of your home, gutting the kitchen, and rehauling the bathrooms, Relator.com thinks you’ll easily spend over $76,000 to make it all happen. Even a full-scale kitchen makeover can run over $50,000, depending on your penchant for brass hardware, custom cabinets, and top-of-the-line appliances.
So how much will you need?
Consider these questions:
- What does a “dream home” mean to you?
- What features about your home do you really like and want to keep?
- What do you want to change about your current house?
- Of the list of desired changes, what are the top priorities?
Be sure you make a plan before shopping around for contractors or falling in love with marble tile. Once you have a clear idea of what you want and how much it costs, you can focus on financing opportunities.
Let’s start learning about HELOCs!
What’s A HELOC?
A HELOC leverages the equity in your home to produce a specific line of credit you can draw from for home upgrades and renovation expenses.
HELOCs differ from other home renovation financing opportunities because you don’t receive the funds in a lump sum. Rather, you have access to a pool of money you can tap as needed.
Think about HELOCs like a home renovation credit card since the two share some fundamental features:
- You can draw from HELOCs over time as needed—there’s so much flexibility!
- There’s a max limit of available funds.
- You must pay back any amount you borrow with interest.
Say you have a $20,000 line of credit on your card. You’re likely not going to spend it all in one place; instead, it might go toward groceries, utilities, entertainment, travel, etc. The same idea applies to HELOCs. Most renovations require capital at different times, depending on the specific project, required labor, trade costs, materials, and more. So it’s nice to only use the funds you need.
With a HELOC, you’re borrowing against the value of your home, so they’re most helpful when you’ve built up significant equity.
Here’s a quick refresher on what “equity” means. To calculate the equity you have in your home, subtract your home’s value from what you owe (what’s left on your mortgage). So, if your home’s value has skyrocketed over the past year, you might have more equity than you realize.
Say your home is worth $550,000, and your primary mortgage is $350,000. In this case, you have $200,000 in equity. A HELOC enables you to access much of that equity (more on that later) for your dream house upgrades.
HELOC Nuts and Bolts
Like any financial tool, HELOCs have a lot going on—getting a HELOC is a much more involved process than opening a new credit card. So what goes into securing these loans?
First, you have to understand how HELOCs work.
HELOCs have two general phases:
- The draw period, and
- The repayment period
Most banks offer a draw period of 10 years—though hopefully, your home reno timeline doesn’t take that long, even with expected construction delays! You can use your allotted funds as needed throughout that time frame. So if you wanted to upgrade your kitchen and wait a few years to button up your landscaping and curb appeal, the money would be there waiting for you!
You’ll only have to make small, interest-only payments during this time, but you can start to pay back the principal as well if you have the funds! Plus, as a bonus, you don’t have to make interest payments on the money you don’t use. So if you have $100,000 available but only use $80,000, you don’t have to make interest payments on the remaining $20,000. This feature makes HELOCs a flexible financing tool.
Next, comes the repayment period, often lasting about 20 years. During this time, you’ll have to repay the loan in full based on the current interest rate. Remember, the interest rate is variable, so if you have a lower interest rate, try to put more toward your balance.
3 Qualifications You Need For A HELOC
How can you access this revolving source of dream home funds? Here’s how to qualify for a HELOC:
1. Decide If You Have Enough Equity In Your House
Most lenders won’t give you access to the full equity in your home. Instead, they’ll use a loan-to-value ratio to determine how much you can borrow.
You can calculate this by dividing the primary mortgage amount by your home’s value. You’ll then turn the result into a percentage.
Let’s bring in some numbers. If your house is worth $550,000 and you owe $350,000, your loan-to-value ratio is 64%. But some lenders will go as high as 80% or more.
Okay, so how much can you actually borrow?
That requires a little more math (or a HELOC calculator, whichever you prefer).
We’ll assume the same home value and mortgage amount and say that your excellent credit gets you a loan-to-value ratio of 80%.
- First, you’ll multiply the home’s value by the loan-to-value ratio. In this case that’s $550,000 x 0.8, which equals $440,000.
- Next, you’ll subtract $440,000 from the amount you still owe on the mortgage, $350,000, to get a max $90,000 line of credit—that would sure make a beautiful new kitchen!
Since housing prices are at an all-time high, you may have built up more equity than you thought. This situation can be a double-edged sword.
On the one hand, if you have more equity (and meet all other requirements), you may be able to qualify for a higher HELOC than anticipated, leading to an incredible dream house.
Conversely, you must be careful about how much you spend on your home renovation in case home values decline significantly. In most cases, you don’t want to end up putting more into the house than it’s ultimately worth.
2. Know Your Debt-To-Income Ratio
There are a lot of ratios in HELOCs, and one of the most important qualifying ones is how much debt you carry.
Your debt-to-income ratio shows how much of your monthly income goes toward your debt. If your number is too high, you may not be eligible to take on more debt. Each lender sets its own standards, but most look for a number under 40%.
3. Understand Your Credit Score
Like securing a mortgage, lenders use your credit score as a metric for giving you a HELOC. Again, the exact number varies by lender, but you’ll likely have to be in the high 600s to be considered, and the better your credit score, the better your rate.
4. You Can “Lock” Your HELOC
One interesting thing is that once you do the home project you had in mind, you may want to “lock” in your rate by converting the used portion of your HELOC into a Home Equity Loan. This strategy is particularly helpful if you want to pay down the debt quickly and don’t want the interest rate to change over time. Home equity loans are usually from 5-20 years, and then a portion of your payment will go towards the principal each month.
The other benefit is that if you didn’t use the entire HELOC amount, you can use it in the future. So if your HELOC is for $90,000 and you do a $50,000 kitchen renovation and lock in this amount as a home equity loan, you’d still have access to a $40,000 HELOC for future projects.
When HELOCs Aren’t So Dreamy
You don’t want your venture of a dream-home renovation to turn into a nightmare, so watch out for the common mistakes homeowners make with HELOCs.
You Aren’t Prepared For The Payments.
Unlike most credit cards, there may be some upfront costs to establishing a HELOC. While these fees will likely be more minimal than alternative routes, you’ll still need enough cash on hand to cover title searches, appraisals, and other closing costs.
Remember, with HELOCs, you use your home’s equity as collateral for the bank. In turn, they often will put a lien on your home, giving them the right to take it should you be unable to make payments. You don’t want to take out a HELOC if you aren’t sure you have a stable cash flow to repay the loan.
You Didn’t Account for Variable Interest Rates.
A lot of your loans, like your primary mortgage, may have a fixed interest rate. So no matter what happens over the life of the loan, you’ll pay the same fixed rate (unless you refinance).
But most HELOCs use variable interest rates. Since the interest rate can fluctuate, it could dramatically change how much you pay long-term. This is especially important to consider given the current economic conditions where interest rates have been going up and may continue to climb.
You’re Not Thinking “Big.”
Since HELOCs come with upfront costs, underwriting, and other administrative processes, it’s essential to use this vehicle to the fullest extent. A common mistake people make is using HELOCs for minor fixes instead of considerable renovations.
You wouldn’t want to go through the hassle of establishing a HELOC only to buy a couple of paint cans and a new light fixture. It’s often beneficial for more significant projects like adding a pool in your backyard, making an open concept main floor, gutting the kitchen, and other large-scale projects.
You Took Out Too Much.
While HELOCs help you fund bigger projects, you don’t want to run into the issue of borrowing too much. When you do that, you run the risk of spending more than the home is actually worth. You don’t want to spend more money than you have to, especially if you plan to use your home’s equity in the future. Or, if your housing value decreases and you need to sell your home, this could leave you underwater on your mortgage.
From HELOC To Dream Home
Though experts anticipate a cooling-off period for the housing market, you may want to stay where you are. If you don’t want to move but aren’t in love with your home, you can remodel it, so it becomes your dream house.
A HELOC is one option for funding this endeavor. Be sure to carefully weigh the pros and cons of this vehicle as you decide how to best turn this dream into a reality.
Now all that’s left to do is set up a “dream home” board on Pinterest and search for stunning inspiration.
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