The Importance of Home Equity Loans for Remodeling

Historically, home equity loans have been an important source of funding for home improvement spending. The following analysis demonstrates this relationship and examines what impact recent declines in home equity loan use have had on the remodeling sector, as well as the positive effects of the residential energy-efficient tax credits. In particular, as home equity withdrawal declined during the Great Recession, remodeling spending fell. But the decline in remodeling activity was tempered by the existence of the tax credit programs.

According to the Census Bureau’s American Housing Survey (AHS), in 2005, 48% of home equity loan dollars were used for home improvement. That percentage has grown in recent years, increasing to 49% in 2007 and 51% in 2009 (the most recent edition of the AHS).

Given this connection, there is a strong correlation between home equity loans and remodeling over time. The following graph plots the stock of outstanding home equity loans (from the Federal Reserve Flow of Funds; third quarter 2011 data not yet available) and the total amount of home improvement spending for owner-occupied homes (from the Census Bureau’s Construction Spending survey).

To focus in on the cause-and-effect relationship between home equity loans and remodeling, the following graph charts remodeling spending against net home equity withdrawal (gross new home equity loans minus paydowns of existing home equity loans). There is a strong correlation until the onset of the housing crisis, when the linkage weakens due to the dramatic contraction in home equity loan use. This is also a period when Congress significantly improved tax credits available to homeowners to make energy-efficient improvements to their homes.

Given these recent changes, we can estimate the long-run correlation between home equity loan use and home improvement spending, as plotted in the next graph by examining the 1993-2008 period (1993 is the oldest data available). A simple statistical test reveals a positive correlation, with more than one-third of the quarter-to-quarter variation in improvement spending associated with changes in home equity withdrawal.

Using the estimated statistical relationship between net home equity loans and home improvement spending, we can examine a counterfactual policy, whereby the tax credits did not exist (red line below) and compare that to the historical data of remodeling spending (blue line). In effect, the red line plots what remodeling spending would have been in recent years absent the tax credit programs.

The estimates and the data below indicate, for example, that improvement spending was $21 billion higher in 2009 due to the tax credits. This matches well with IRS data for 2009, which indicate that $25 billion of qualified improvement spending was claimed on tax forms to generate nearly $6 billion in realized tax credit claims.

It is also interesting to note on the graph above that Census data show a notable decline in home improvement spending taking place in the third quarter of 2011. As the 25C remodeling tax credit was weakened at the end of 2010 and is scheduled to expire at the end of 2011, this decline is consistent with expectations (that is, graphically, the blue and red lines will converge after the tax credit program ends).

In summary, this analysis demonstrates two important results: (1) access to home equity loan debt is important for the remodeling sector; and (2) the tax credits for energy-efficient remodeling had a large and significant impact on the remodeling sector during the Great Recession.

Of course, there are other determinants of remodeling spending, such as the volume of existing homes sales, as the following graph illustrates. And just as new home sales will increase in response to an increase in existing home sales (as existing homeowners find buyers for their current homes, enabling them to purchased a newly constructed home), total remodeling expenditures will also increase with growth in existing home sales.

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