Should you use a PACE loan or home equity loan to finance home improvements?
A PACE loan and home equity loan both enable you to finance home improvements. Both of these financing options offer positives and negatives, depending on your personal circumstances and objectives.
The key difference between a home equity loan and a PACE loan is that a specific borrower is responsible for paying a home equity loan while a PACE loan is attached to a specific property and not an individual borrower. The property owner at any given point in time is responsible for paying the PACE loan, which is added to your property tax bill.
Theoretically, if you take out a PACE loan on your home and you sell your property, the new home owner is required to continue to pay the PACE loan, until it is ultimately paid off. With a home equity loan, you are always required to pay off the loan when you sell your property.
Now that you have a basic understanding of how they work, the question becomes which loan is right for you? We compare the advantages and disadvantages of a home equity loan and PACE loan below so that you can select the option that best meets your needs.
As the name suggests, a home equity loan enables you to take cash out of your home by accessing your equity. The proceeds from a home equity loan can be used for just about any purpose, including but not limited to making improvements or renovations to your home.
Review How a Home Equity Loan Works
Positives of a home equity loan as compared to a PACE loan include the following:
You typically pay a lower interest rate which saves you money
Fixed interest rate and monthly payments
No restrictions on how you use the loan proceeds
A home equity loan is junior in priority to your mortgage so there should be no issue with your current mortgage lender
Much wider program availability
Prepayment penalties are less common
The negatives of a home equity loan relative to a PACE loan include potentially more challenging qualification requirements, you are personally responsible for the loan and you may be eligible for a smaller maximum loan amount.
Specifically, lenders usually limit the combined loan-to-value (CLTV) ratio for a home equity loan to 80% to 90% of your property value (before any improvements). The CLTV ratio equals the total of all loans secured by a property, including your mortgage and home equity loan, divided by the fair market value of the property. Depending on your current mortgage balance and the CLTV ratio used by the lender, you may not be able to take out the home equity loan you want.
For example, if the home equity loan lender applies an 80% CLTV ratio limit, your current mortgage balance is $70,000 and your home is valued at $100,000, the maximum loan you can get approved for is $10,000. In this scenario, a home equity loan may not provide sufficient proceeds to pay for the property improvements you want to make.
If you have enough equity in your home, then the maximum CLTV ratio is less of an issue, and a home equity loan is usually a better financing option than a PACE loan for the reasons outlined above.
The table below shows home equity loan terms including interest rates and fees. We recommend that you contact multiple lenders to confirm the loan amount you qualify for.
As highlighted above, the unique feature of a PACE loan -- which is short for Property Assessed Clean Energy loan -- is that the loan is attached to the property instead of the borrower. Instead of making a monthly loan payment, you pay the loan by paying a higher property tax assessment.
The main advantage of a PACE loan is that some lenders offer 100% financing which means you can access your full property value with the loan. For example, if your current mortgage balance is $70,000 and your property is valued at $100,000, you may be eligible for a $30,000 PACE loan. In short, you may be able to qualify for a larger PACE loan than home equity loan.
Review How a PACE Loan Works
It may also be easier to qualify for a PACE loan than a home equity loan because the qualification process focuses on your property value and homeowners equity as compared to your credit score and other individual factors. If your credit history is less than perfect then a PACE loan could be a good option for you.
Another potential benefit of a PACE loan is that because the loan is attached to the property and not you as a borrower you may not be required to repay the loan when you sell your home or refinance your mortgage. This potentially enables you to keep more proceeds when you sell your property.
While this program feature is highlighted by PACE loan lenders as an advantage relative to a home equity loan, in reality you almost always are required to pay off the loan when you sell your home or refinance your current mortgage. This is because the lender for the person buying your home or your refinance lender requires the PACE loan to be paid off in full.
The new lender does not want another lien against the property that could potentially be senior in priority to their mortgage. So even though you may not be personally responsible for the PACE loan according to your loan documents, you usually are from a practical standpoint.
This reasoning also applies if you currently have a mortgage on your home. In many cases mortgage lenders do not permit you to add PACE loan to your property.
Other disadvantages of a PACE loan compared to a home equity loan include paying a higher interest rate and monthly payment, your loan proceeds can only be used for specific energy efficiency property improvements and some borrowers prefer monthly loan payments instead of paying a higher property tax bill every six or twelve months.
Another key point to consider is that PACE loans require the participation and consent of local governments so program availability is limited. Home equity loans are available in all 50 states whereas residential PACE loans are available in less than ten states.
The final point to keep in mind is that some PACE loans include a prepayment penalty if you pay off your loan early. We advise you to negotiate with the lender to remove any potential prepayment penalty before you move forward with the loan.
In closing, a home equity loan makes the most sense for most borrowers because it is more cost-effective and provides greater financial flexibility. The cases when a PACE loan may be the better option include if you have limited equity in your property or if you have experienced credit challenges.
Sources
“What is a home equity loan?” CFPB. Consumer Financial Protection Bureau, September 25 2017. Web.
"Property Assessed Clean Energy Programs." Office of Energy Efficiency & Renewable Energy. U.S. Department of Energy, 2020. Web.
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