(Updated January 2015)
Coming up with the necessary cash to finance a remodeling project can be the hardest part of the entire task. But creative mortgage refinance strategies can provide the right tools for the job, particularly when property refinancing rates and basic building materials are affordably priced.
With home values rising and mortgage credit easing, we could soon be seeing another surge in home remodeling projects across the United States. Rather than moving to a new property, many consumers are using home improvement loans to pay for more space in their current home, especially extra bathrooms and bedrooms, though kitchen upgrades are still at the top of the remodeling wish list.
Surveys find that more than half of the people who plan to do home improvements look to create special design features in their homes, and 20 to 25 percent define that kind of strategy as one that will make their homes more comfortable or help them "create their dream."
Funding your dreams
To fund your domestic dreams, many experts recommend a mortgage refinance to strategically take advantage of the equity in your home. Here are four home refinance approaches that are especially popular for remodeling projects:
1. Cash-out refinance: Borrow more than your current outstanding mortgage. The loan will cover application fees and closing costs, and you can still walk away with extra cash in your pocket.
A cash-out refinance is very useful if you'd also be able to reduce the interest rate you're currently paying on your mortgage by refinancing. It's also likely to give you the lowest long-term interest rate of any type of home equity borrowing.
The closing costs on a cash-out refinance tend to be higher than for other types of home improvement loans, though. That's because those costs are based on the size of the loan and you're refinancing your entire mortgage, in addition to what you're borrowing for your home improvement project. That's why you usually want to be able to get a secondary benefit as well, such as saving money by lowering your interest rate, to make refinancing worthwhile.
2. Home Equity Loan: A home equity loan is a good alternative to a cash-out refinance when you don't want to rework your entire mortgage. Instead, you just borrow as much as you need and only pay closing costs on the amount you borrow.
With a home equity loan, you can choose a shorter repayment term than you would for an entire refinance, so you can pay off the home improvement debt more quickly than the rest of the mortgage. A shorter term will also lower your interest rate.
Interest rates on home equity loans are attractively priced. Because they're a type of secured debt, backed by the equity in your home, they're usually lower than what you would pay on a personal loan or other type of unsecured debt.
Home equity loans are considered a type of mortgage, so the interest you pay on them is tax-deductible, provided that you itemize deductions on your return and meet certain other guidelines.
3. HELOC: With a home equity line of credit (HELOC), you can withdraw money as needed, like you do with a credit card, for purchasing building materials in phases.
With a HELOC, you don't borrow a set amount up front. Instead, your lender will set a certain figure you can borrow against, and you can draw against that as needed. So if you have a $40,000 limit, you might borrow $3,000 to start, $12,000 later on, then $5,000 at another point, etc.
A HELOC offers a lot of advantages for home equity projects. First, because you can borrow money as needed, it's good for projects that will have periodic, ongoing expenses.
You also only pay interest on the money you've actually borrowed to date. If, for example, you borrowed $30,000 up front but wouldn't need $10,000 of that amount for another six months or a year, you'd be paying interest on that $10,000 while it's just lying around. With a HELOC, you only borrow the money when you need it.
4. Cut costs by switching rates: If you have an adjustable-rate mortgage, shift into a conventional fixed-rate loan. You might save enough to help pay for your renovation while adding valuable equity.
To do this, you need to refinance your adjustable-rate mortgage into a fixed-rate mortgage. While adjustable-rate loans start out with very low rates, they often reset to rates that are higher than what you'd pay on a fixed-rate loan. Refinancing can drop the rate you're paying below what you had been paying on your adjustable-rate mortgage, particularly if you've had that loan for a number of years, prior to the big drop in rates since the Great Recession.
You can also combine the savings from switching rates with a cash-out refinanced to get the money needed to remodel, as described above.
More than ever before, homeowners are looking to do all or part of the hands-on work themselves, by taking advantage of their neighborhood home improvement stores. Save the real muscle for the remodel, because when it comes to paying for home improvements with sweat equity, you really don't have to sweat the money. The only heavy lifting involved is a basic mortgage application, a search for competitive rates, and a little crunching of numbers.
Choosing the Right Mortgage to Remodel
Paying for a remodeling project with a home loan is usually a good idea. But choosing exactly the right type of mortgage instrument may require some planning and calculation.
One of the smartest ways to use a mortgage is to pay for a remodel, upgrade, room addition, or repair to your home. By borrowing against the equity in your property to enhance its value, you essentially grow equity without any out-of-pocket expense. The key to success is to choose your loan carefully.
Refinance or second mortgage
Depending upon how much interest you're paying on your first mortgage, you may or may not want to refinance it to fund the project. If the existing mortgage has a cheaper rate than you can get today, hold on to it, and use a second mortgage to pay for the remodel. Pay off the second mortgage-and the higher interest-as soon as possible, to avoid paying steep finance charges.On the other hand, if your existing loan is an adjustable-rate mortgage (ARM), interest-only loan, or other variety where the interest rate rises, you might be wise to refinance to a less volatile and conventional fixed-rate mortgage (FRM). Roll your remodeling costs into the new loan, and capture a better rate for your mortgage as well as your remodeling project.
Planning for a sale
If you're fixing up your place in order to sell it within the next three to five years, you won't be around long enough to reap the long-term benefits of a 30-year FRM. For the sake of argument, if you plan to remodel this year, and sell it a year from now, you might as well get the cheapest loan available. Consider an ARM with a low 2-year introductory rate. You'll save money, because you'll have already paid it off by selling your home before the loan resets to a higher rate.
Borrow based on cash flow
If you're paying your contractors or suppliers in phases, you don't need a large lump sum up front. A home equity line of credit (HELOC), which works like a credit card and lets you withdraw only when you need the cash, may be your best option. You may pay slightly higher interest, but you won't pay anything until you actually use the money. This could cost less overall than if you took out a loan in the beginning and paid interest for the entire length of the project. Ultimately, don't forget to stick to your plan. One of the most common and costly mistakes homeowners make is that they keep expanding the original project. Soon it grows out of proportion, and the budget overruns totally offset any smart strategies that they had regarding borrowing the money with a lower interest rate.