Many homeowners make the mistake of self-equating “renovation loans” with “home equity loans,” assuming that a renovation loan is a home equity loan. This can have very real, very costly implications. If you have the cash or the equity available, you’ll pay less by sticking your renovation on a home equity line or loan. The interest on those products is currently tax-deductible if you itemize. A renovation loan is neither deductible nor currently itemizable as mortgage interest, making it a less efficient financing vehicle in many circumstances.
The opportunity cost of paying cash
Paying for a remodel with cash has benefits and drawbacks. On one hand, it feels good to spend only what you have. You can take comfort in knowing the cost won’t haunt you with monthly bills or balloon into something catastrophic if life happens, as they say (or at least as you don’t). No interest. No debt. No problem. Or maybe there is a problem. Here are things to consider if you’re planning to go the old-fashioned route to finance your remodel:
Cash isn’t as king as you thought: If you plan to use liquid savings or investments to foot the bill, consider this: Money has opportunity cost. In the case of a bank savings account, which paid a median 0.09% in interest as of this writing, that cost is virtually nonexistent. For a stock market that returned 30.8% in 2019, costs could be quite significant. Working with a Financial Advisor Georgia can help you weigh whether liquidating investments to fund a remodel actually makes sense given your broader financial picture.
HELOCs vs. home equity loans: flexibility vs. predictability
While these products draw on your home’s equity, they function in vastly different ways. A HELOC is a “use-what-you-need, pay-as-you-go” product. You use your newfound equity as a line of credit, drawing and repaying what you need. As such, it’s ideal for a project with multiple or elongated phases. You only pay interest on your current balance, so you can wait to draw additional funds until you have more clarity about final costs. On the downside, many HELOCs feature variable interest rates. This means that over a long project, your payment can fluctuate if the market shifts.
A home equity loan gives you an upfront chunk of cash at a fixed rate. You then repay it over an agreed-upon term. This product is best when you have one phase and a firm price. If you already have a signed contract from a contractor, you know exactly how much you will need in funding and when you will need it. Because you’ve locked in the amount to borrow from day one, you’ll come to the table only once with your lender. On the flip side, if you need more cash than you initially realize, you’ll have to apply for an entirely new loan.
Tax treatment matters more than most people realize
You may deduct the interest on a loan secured by your main home or second home, on home equity loans of up to $100,000 ($50,000 if married filing separately). The funds used to make substantial home improvements qualify, but the same is not true of pooling your outstanding card balances.
When debt is used to acquire a home, improve one, or for some other purpose associated with a residence, the IRS lets you take the interest as an itemized deduction. That can make the effective rate on the borrowing less.
This gets more complicated if you’re subject to the alternative minimum tax (AMT). Home equity debt interest is not an itemized deduction unless the money is used for home improvements. If you’re in AMT, the deduction is usually less valuable, if you get it at all.
Cost basis and capital gains down the road
One important aspect of homeownership that many people overlook is the tax implications of capital improvements. These are big-ticket maintenance items that don’t just maintain the home’s current value but make it more valuable or useful over time. Replacing broken windows is a repair. Adding a sunroom is a capital improvement.
Capital improvements increase your home’s adjusted cost basis, which can save you on taxes when you sell. The higher your basis, the smaller your capital gain when you sell the property for a profit. Most homeowners are aware that they can exclude up to $500,000 of capital gains from taxes if they are married and filing jointly or $250,000 if they are single or married filing separately. But if you’ve lived in your home a long time or live in an area where home values have increased dramatically or both, it’s not hard to blow past that exclusion.
ROI is real, but it’s not the whole answer
On average, homeowners recoup about 50% to 70% of their total investment in kitchen remodels when they sell their house. This percent not only covers the cost of remodeling and upgrading, but also your time to grill all summer and eat takeout every night. Wildly worth it, right?
Actually, maybe. A kitchen is more than just where you cook meals; it’s the center of your home and probably the biggest source of pride. Renovating it might make the effort worth it once it comes time to sell, especially if you’re replacing a dated kitchen in a sought-after neighborhood. But while potential buyers are wowed by your trendy appliances and Calacatta marble countertops, your one true desire is enough storage space and a convenient work triangle.
Integrating a remodel into your broader wealth plan
A major remodel isn’t all it’s about, though. It coexists with retirement savings, college funding, estate planning, and all the other moving parts of your financial life. Putting the cost of a renovation in context with your overall plan – versus just making it another “over here” item on a long list of obligations – clarifies where it really strains things and where you’ve got some wiggle room.
You can test-drive a few different ways to pay for that remodel against what’s also coming due, including your current lifestyle, your other goals, and your other priorities. That means you’re looking at the short- and long-term effects of taking out a home equity loan versus pulling from your investment accounts, and all it takes is running the numbers through some cash flow modeling.
The financing method that looks cheapest on paper isn’t always the one that fits your actual financial picture. The goal is to fund the project in a way that protects your liquidity, minimizes your tax exposure, and doesn’t compromise what you’ve already built.
