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The most popular way to finance home improvements is the cash-out refinance mortgage. However, a cash-out refinance may not be your best choice. Experts say it only makes sense when:
- You can a better mortgage rate and/or terms by refinancing
- The added expense involved (including closing costs) is less than the cost to finance your renovation another way
- You will break even on the refinance costs before you plan to sell your home
Research your options. Compare the pros and cons carefully, and determine how badly and quickly you need the renovation completed.
Do the math
A cash-out refinance for renovation can be a smart choice. Of course, this will depend on your situation. Refinancing could lower your mortgage interest rate. You may be able to shorten the term, too.
Say you bought a $300,000 home 10 years ago and borrowed $240,000. You now have 20 years left on a 30-year mortgage at 6 percent interest, with a balance of about $200,000 and a monthly payment of $1,439.
By refinancing to a 15-year mortgage at 4.5 percent, and taking an additional $15,000 for home improvements, you’d increase your monthly payment by $212. But you’d shorten your mortgage payoff by five years, and save over $63,000 in mortgage interest over the life of your loan.
That’s more than enough to offset your closing costs, which average about $5,000 for a cash-out refinance of that size.
Alternatively, you could refinance to a new 30-year loan at 4.80 percent. That would lower your new payment by over $300 a month while getting you $15,000 for renovation. The bad news? You add ten years to your mortgage repayment schedule.
The 15-year refinance has a breakeven period of just over two years, while it would take nearly four years for you to recoup your refinance costs with the 30-year loan.
Weighing the good and bad
Ralph DiBugnara with Residential Home Funding says a cash-out refi has its pros and cons.
“Interest rates are somewhat higher today than just a few years ago. But money is still cheap to borrow. And home values are climbing at a faster rate in 2018,” he says.
Joshua Harris, clinical assistant professor of real estate at NYU’s Schack Institute of Real Estate, agrees.
“The benefits include getting the lowest cost of borrowing generally available to you,” Harris says. “Also, you can potentially deduct the interest on your taxes. You also have the ability to increase your home’s value by renovating.”
The drawbacks? You’ll likely pay more monthly. The surcharges for cash-out refinancing apply to the entire loan amount, not just the cash-out.
“There’s also the general risk that your cost of improvements will be greater than the increased value of the improvements to your property. That lowers your equity and may decrease your overall wealth,” adds Harris.
Tapping into your equity
A cash-out refinance isn’t the only route you can take to finance a renovation.
The Home equity line of credit (HELOC) allows you to borrow against your home’s equity, using your home as collateral. You can withdraw money, up to a pre-approved spending limit, during a set draw period (often the first 10 years), and repay it over the remaining term of the loan. Costs are low, even zero.
“The interest rate is usually adjustable,” says Matt Hackett, operations manager for Equity Now. “Loan amounts can vary, so it may be possible to fund larger projects if there’s enough equity in your home.”
HELOCs are great when you need flexibility for an ongoing remodel with several stages, or when you don’t know exactly how much you’ll need, or when you don’t need to borrow a large amount.
Here’s an alternative: refinance without taking cash out, but add a HELOC for your repairs. Rate and term refinances (taking no cash out) are cheaper to do and make sense if you will recoup the costs before you sell or refinance again.
The home equity loan is another option. This loan delivers a lump sum at closing and is good when you need a large amount upfront. Home equity loans are sometimes called “second mortgages.” Closing costs are higher than those of a HELOC, but your interest rate is usually fixed, making it easier to budget.
Riskier alternatives to cash-out refinancing
Say you don’t qualify for a cash-out refi, HELOC or home-equity loan. In that case, you might want to consider:
A personal loan also called a “signature” or “unsecured” loan. With this product, you don’t use your home as collateral. Personal loans can be obtained quickly, but have much higher interest rates. Many (but not all) lenders max out at $35,000 for personal loan amounts, and most require excellent credit.
Then, there’s credit card borrowing. This is often the quickest and easiest way to fund a renovation. But experts don’t recommend it. “Average rates today are 13 percent or higher. This will cost you almost three times as much is a cash-out refi or HELOC,” says DiBugnara.
However, using a rewards card to fund improvements, and then paying it off with home equity financing could work in your favor.
FHA rehab loans
The FHA 203(k) rehab loan bundles your refinance and rehab costs into one loan. And the loan amount (96.5 percent loan-to-value) is based on the improved value of your home, so even if you have little or no equity, you may be able to qualify.
However, FHA mortgages come with one steep drawback: the required mortgage insurance, which comes to 1.75 percent upfront, plus a monthly premium. And it remains in place for the life of your loan. Your lender has to be FHA-approved, and your renovation costs must be at least $5,000.
“For those with limited equity in their home, a 203(k) rehab loan can be a terrific option,” says Christopher Guerin with eLEND. “This loan bases the value of your home after improvements are completed. That’s unlike a traditional refi, which only allows you to access equity based on your home’s value prior to any renovations.”
This is a good option if you have less than 20 percent equity built up in your home.
“An FHA consultant will work with your contractor to ensure that repair costs are in line with the market. Also, the contractor gets half the money for work at closing. They get the other half at the completion of work. This gives them an incentive to finish in a timely manner,” says DiBugnara.
When you have decent equity in your home, however, you can try a cash out refinance from the FHA. It allows a maximum loan-to-value of 80% and is lenient about credit scores.
When all else fails
Two other options remain: pay in cash or postpone.
“Your best choice may be to save money and pay for your home improvement in cash. This is the option that produces the least amount of risk and the highest overall wealth. But it takes more time and requires patience,” says Harris.
Or, you could delay the project indefinitely.
“Ask yourself: does the renovation add value? Is it worth the cost? Can I finance the improvements and still increase the value of my investment? Your goal should be to recoup the financing costs within five years,” says DiBugnara.