Using a home equity loan for remodeling projects is one of the smartest uses of your funds, because there are additional benefits that aren't an option when you use the loan for purposes such as consolidating debt. A home equity loan is when you borrow against the equity you've accrued in your house after having made consistent mortgage payments over the years, and you receive that equity as cash that you pay back over a set period of time. 

When you use a home equity loan for home improvements, the interest is tax deductible while you're adding value to your home by increasing what the property is worth. So, you're getting a maximum financial benefit because you've reinvested the funds into an asset (your house) that will pay back when you sell it at a higher price down the line, as well as saving yourself years of interest on payments.

Here are some of the most important pros and cons to consider when using a home equity loan for a remodeling project, how to decide whether you should use a home equity or a home equity line of credit (HELOC), as well as alternative ways to pay for home projects if an equity loan isn't right for you.

Pros of using home equity for remodeling

The main benefits of using home equity for remodeling are the ability to deduct the interest on your home equity loan from your taxes and to enjoy the windfall from your home improvements when you sell your property later on. Plus, you get to enjoy living in your new and improved home until you sell it. 

The interest is tax deductible

The interest on your home equity loan is tax deductible as long as you use the money to "buy, build, or substantially improve your home," according to the IRS. However, there are limits to how large of a loan you can take out in order to qualify.

Interest rates are lower than other loans

Home equity loans have low interest rates compared to other kinds of loans such as personal loans and credit cards. Current home equity rates are just under 7% but personal loans are at 10.7%, according to Bankrate, CNET's sister site. But keep in mind, the interest rate a lender offers you will always depend on personal financial factors such as your credit score and how much debt you're carrying, which is why it's important to keep your debts and other life expenses low whenever possible. 

You receive a lump sum at a fixed-rate

With a home equity loan, your interest rate will be fixed, so you don't have to worry about it going up in a rising interest rate environment like the one we're in today. Your monthly payments will always be consistent and never increase or decrease like they do with a HELOC. 

Renovations increase the equity in your home

You are replacing and building up more equity in your home. Even though you took cash out of your home for your loan, using the money to renovate means you're increasing your property's value, therefore increasing your equity. But it matters what type of renovation projects you undertake, as certain home improvements offer a higher return on investment than others. For example, a minor kitchen remodel will recoup 71% of its value when you sell a house compared to 61% for a deck addition, according to a 2022 report from Remodeling magazine that analyzes the cost of remodeling projects.

Cons of using home equity for remodeling

While there are advantages to home equity loans, there are also downsides to using them for home repairs. If property values decline when a recession or other disruptive economic event occurs, the improvements won't end up increasing your home's worth the way you had planned because your home will have gone down in value overall. 

You can lose your home

Your home secures the loan.If you miss payments or can't pay back your loan in full for any reason, you can lose your house to your lender or financial institution, who will use the proceeds from the sale to pay themselves back what you couldn't. 

Loan limits for interest deductions

Your loan interest is only tax deductible up to $750,000 for joint filers or up to $375,000 for single filers.

Some projects are a better use of funds than others

If you don't plan to sell your home in the future, using the funds for improvements may not make sense. Some renovation projects don't add as much value as others. For instance, putting in new windows has an ROI of just 66%, but installing a new garage door has an ROI of 93% when you sell your house, according to the Remodeling magazine report. 

Home values could fall

While property values have skyrocketed over the last two years, if house prices drop for any reason in your area, your investment in improvements won't have actually increased your home's value. When you end up owing more on your mortgage than what your home is actually worth, it's called negative equity or being "underwater" on your mortgage.

Home equity loan vs. HELOC: Pros and cons

HELOCs are similar to home equity loans in that you can deduct the interest from both types of loans from your taxes, but there are a few key differences. A HELOC is often better when you want more flexibility with your loan, such as if you need to continually withdraw funds for a recurring expense like college tuition, or don't know the exact amount of funds that you need for an on-going project such as home renovations. Here's the breakdown of the pros and cons of using either a home equity loan or a HELOC for home remodeling projects.

Using a home equity loan for home improvements

Pros

• Your interest rate is fixed: With a fixed-interest rate you don't need to worry about your payments going up, or paying more in interest over time. Your monthly payment will always be the same, no matter what is happening in the economy.
• You receive a lump sum: You receive all of the cash upfront in one payment, so you have access to all of your funds immediately.

Cons

• You have to use all the funds: With a HELOC, if you don't end up needing your total credit limit, you're not required to spend it all. But with a home equity loan, you receive all the money at once whether you need it or not. That means you also have to make payments on the total loan amount from the beginning of the loan term, which will likely be higher than the interest-only payments you can make during the decadelong draw period of a HELOC.
• Your interest rate remains fixed when rates go down: If interest rates go down for any reason, you are stuck with your rate and can't change it.

Using a HELOC for home improvements

Pros

• You have a revolving line of credit: A HELOC functions more like a credit card that you access whenever you need funds, which offers you more flexibility than a home equity loan.
• You can make interest only-payments: You can make interest-only payments during the draw period of your HELOC, the set time period which you can take money from your line of credit (usually a period of 10 years), which means you can borrow a large amount of money for an extended period of time while only making minimum monthly payments.
• You can convert a HELOC into a home equity loan: If interest rates start rising, you have the option to convert your HELOC to a fixed-rate HELOC or a home equity loan to help save you money. (You can't change your interest rate with a home equity loan.) 

Cons

• Variable interest-rates can be too much: Your monthly HELOC payment will go up and down depending on current interest rates trends, so your budget must be flexible enough to allow for the possibility of higher payments at any time. 
• Monthly payments increase after the draw period: After your draw period is over you are required to make payments on both the interest and the principal balance of your loan, which means your monthly payment will increase significantly when your repayment period begins. A typical HELOC repayment period is 20 years.
• Your home could be repossessed: Your home secures the loan.Just like a home equity loan, you need to put your house up as collateral to secure the loan, so your bank or lender can repossess your property if you fail to make your payments. 

Alternatives to using your home equity for home improvements

If using a home equity loan for remodeling doesn't make sense for your particular situation there are alternative financing options to consider. As with all forms of credit, make sure you can responsibly manage the amount of money you're borrowing. As a best financial practice, never use a home equity loan -- or other type of financing -- for expenses other than the original intended purpose of the loan.

Cash-out refinance: A cash-out refinance is a good option for homeowners looking to lock in a lower interest rate on their mortgage. A cash-out refi provides you with a lump sum of cash just like a home equity loan, but it replaces your current mortgage so you only have to make one monthly payment, while also saving money on interest over the course of your mortgage. Interest rates, however, typically have to be lower than your mortgage rate for this option to make sense. 

Personal loans and credit cards: Personal loans and credit cards tend to have higher interest rates than home equity loans or HELOCs, but you don't have to put your house up as collateral to secure the funds.

The bottom line

Home equity loans can be a cost-effective way to borrow against your home's equity when it comes to remodeling, because they are tax deductible and provide the means to increase the value of your home. But before you decide on how to fund your next home remodeling project, consider the pros and cons of a home equity loan and a HELOC to determine which one best suits your needs.