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Home remodeling: How to finance your project

Pete Gerardo
The Mortgage Reports contributor

In this article:

The right home improvements can add value and equity to your property. And the less you spend paying for home remodeling, the higher your return on investment.

  • The cheapest financing is usually backed by your home: FHA 203(k) refinancing, cash-out refinancing, home equity loans and home equity lines of credit (HELOC)
  • For smaller amounts, or for those who may not qualify for a mortgage, personal loans or credit cards might be a better choice

You can even combine them — for instance, use a zero-interest credit card for 18 months and then pay it off with a HELOC, home equity or personal loan. Or use a rewards card to get the points, then transfer the balance to a lower-interest option.

Verify your new rate (Jun 24th, 2019)

Home remodeling costs are up

If home remodeling ever gets an international symbol, the twin masks of comedy and tragedy would be a good choice. The smiling comedy mask would represent the joy of looking at paint swatches and tile samples.  And the frowning face of tragedy? That’s you figuring out how to pay for everything.

In 2016, U.S. homeowners spent an average of $5,157 on home improvements, an increase of nearly $2,000 from 2015.

Related: $165,000 to remodel or $165,000 to move (Choose wisely)

Home remodeling can take a big bite of your income. Unless you have enough money saved, you’ll have to finance the improvements with more loans.

Fortunately, there are plenty of relatively low-cost ways to finance home renovations. As long as you make a realistic budget and don’t try to turn your one-story ranch into an Italian Renaissance palazzo, you should be fine.

In fact, your remodeling efforts could actually increase the resale value of your home.

Cash-out mortgage refinances

A cash-out mortgage refinance is a popular way to pay for home renovations. With a cash-out refinance, you refinance the existing mortgage for more than the current outstanding balance. You then keep the difference between the new and old loans.

If you have a lot of equity in your home, a cash-out refi lets you free up a large sum. However, if you don’t have enough equity or your credit score is “meh,” you may find it hard to qualify for a sizable loan. And if you don’t need a lot of cash, this is a very expensive option.

That’s because lenders usually add surcharges to their pricing for cash-out refinances, and those apply to the entire loan balance, not just the cash-out. If you refinance a $200,000 mortgage with a $210,000 cash-out loan, you’ll likely pay at least one extra point in fees for the privilege. That’s $2,100 to borrow $10,000.

Related: 4 alternatives to a cash-out refinance

Most cash-out refinances are limited to an 80 percent loan-to-value ratio (LTV) – the amount of the loan vs. the home’s market value.

In theory, cash-out refinancing is available to people with credit scores as low as 620. In reality, many lenders set their minimums around 640.

Home equity loans and HELOCs

Home equity loans and lines of credit (HELOCs) are both mortgages, secured by your property. They may also be called “second mortgages” because usually, there is already a first mortgage against the property, and the new one is the second one. Second mortgages are riskier to mortgage lenders, so their interest rates are higher.

The amount of the first mortgage plus the amount of the second mortgage, divided by the home’s appraised value is called the combined loan-to-value, or CLTV.

Home Equity Loans

A home equity loan is a (usually) fixed-rate loan that’s secured by your house. In most cases, lenders allow a CLTV of up to 80 percent. That means you can borrow up to 80 percent of your home’s market value minus what you still owe on the mortgage.

Related: Home equity loan or HELOC (What’s best for you)?

Highly-qualified applicants may finance up to 90 percent CLTV, So if you own a home worth $100,000 and your current mortgage balance is $70,000, you could (with excellent credit and income) probably borrow an additional $20,000, for a total debt of $90,000.

Home equity loans tend to be approved faster than cash-out refinances. They also tend to have lower closing costs. On the other hand, you may have to settle for a smaller loan and a higher interest rate.

Home Equity Lines of Credit (HELOCs)

HELOCs are revolving credit lines that typically come with variable rates. Your monthly payment depends on the current rate and loan balance.

HELOCs have two phases. During the draw period, you use the line of credit all you want, and your minimum payment may cover just the interest. You’re allowed to pay it down or off at will.

Related: Convertible HELOCs offer the advantage of a fixed rate

Eventually (usually after 10 years), the HELOC draw period ends, and your loan enters the repayment phase. At this point, you can no longer draw funds.

Beware! Your payments can skyrocket once the repayment phase begins – i.e., once you begin repaying both principal and interest on the loan

If, for example, you have a 15-year HELOC with a 5-year draw period. You borrow $20,000 during the draw period and make interest-only payments at 5 percent. That’s $83 a month. But when you enter the repayment period, your balance is amortized over ten years. If your interest rate doesn’t change, your new payment is $212.

Personal loans and credit cards

Personal Loans

These accounts are also called “signature loans” or “unsecured loans.” That’s because you put up no collateral for the lender to repossess if you fail to repay the loan.

The main advantage of a personal loan is the speed and simplicity of the application and approval process. The setup costs are also low or even zero.

Related: P2P (peer-to-peer) home lending could be game-changer for millennials

But the rates for personal loans are much higher than for cash-out refinances and home equity loans. And the loan amounts can be limited (often $35,000 on peer-to-peer sites). Note that just because the loan is unsecured, you’re still on the hook for the balance. The lender can take you to court.

Credit Cards

As of July 2018, credit cards in the US carry an average interest rate of about 17 percent. This makes plastic one of the costliest ways to finance home remodeling.

Related: Can you pay your mortgage with a credit card?

In general, there’s only one credit-card-financing scenario that makes sense. Get a new card with an introductory zero-percent APR (the intro period is typically 12-to-18 months). Use the card to pay for the home improvements, but repay the balance before the interest rate kicks in.

You can also use a rewards card to accumulate points or travel, then pay it off with other loans with lower interest rates.

FHA 203(k) loans

These loans can be ideal for buyers who’ve found a good “fixer-upper.” A 203(k) loan allows you to borrow for both the home purchase and improvements with a single loan. You can also refinance with a 203(k), replacing your old mortgage and adding extra for home improvements.

It’s like a home equity loan for homeowners with little or no home equity. The advantage is that the loan amount is based n the improved value of the property, not the current appraised value.

Related: FHA 203(k) rehab loan benefits and downsides

Because 203(k) loans are guaranteed by the FHA, their underwriting guidelines are more flexible than many private products. And with decent credit, you only need 3.5 percent down or home equity.

But the house must be a primary residence, and the renovations can’t include anything the FHA defines as a “luxury.”

Because of the paperwork involved, and the requirement that you use only licensed contractors, these loans aren’t for people who want to beautify a property themselves. They are best for “heavy duty” rehabilitation work.

401(k) loans

With a 401(k) loan, you can borrow up to the lesser of $50,000 or half the value of your savings. Then, you repay the interest and principle into your account. In other words, you repay yourself.

However, these loans come with significant risk. First, you can’t contribute to your account while you owe a balance against it. That could really impact your retirement if repayment takes a long time.

Related: Read this before borrowing from your 401(k)

Second, if you leave your employer (or get laid off) and don’t repay the loan within 30-to-60 days, the balance becomes taxable and you’ll also be slapped with a 10 percent fine. (You won’t get penalized if you’re at least 55 years old.)

If you don’t repay the loan before you turn 59 1/2, any outstanding balance will be considered taxable income to you, but you won’t have the 10 percent penalty.

Don’t borrow from your 401(k) if you might be “separated” from your employer in the near future.

Be sure to comparison shop!

When it comes to any loan, Rule #1 is always shop around!

It’s not a bad idea to start with a quote from the bank that issued your first mortgage, but don’t stop there. Research current interest rates and terms, as well as closing costs and the other fees associated with different loans.

And don’t limit yourself to just one type of financing option. As long as you don’t take on too much debt, you can combine any of the borrowing methods above to finance your repairs and renovations.

Verify your new rate (Jun 24th, 2019)