How to Pay for Home Renovations Without Breaking the Bank

The home renovation process often starts with something simple, such as a homeowner’s desire to replace the ugly tile in the bathroom that they’ve put up with long enough, or the need to repurpose an unused dining room into a playroom as the kids grow. Or it may be that a homeowner has been saving ideas for years on Pinterest for a grand master suite and the time is right to convert a cramped bedroom. Home renovations are exciting and thrilling—or necessary and financially terrifying—but before homeowners can start getting quotes from the best home renovation contractors, they may want to think about how to pay for home renovations.

Time required: Varies, depending on the size of the project and the sources of funding
Difficulty: Beginner, with expert input
Estimated cost: Varies. The average home renovation cost ranges from $18,161 to $76,367

What You’ll Need

Photo: istockphoto.com

Preparation is key when funding home renovations, whether homeowners plan to pay for everything with their savings, take out a loan, or tap into their home equity. By mapping out their renovation plans in detail, taking stock of their financial situation and needs, and making a list of potential contractors and lenders to work with, they can better anticipate every step in the process and avoid unpleasant surprises. As they begin exploring their funding options, it’s a good idea for homeowners to assess everything they will need to make the process go as smoothly as possible, including:

• Defined plans for the renovation
• Material estimates
• Quotes from several general contractors
• A solid budget with plans for cost overruns
• Contacts at several local and national banks or lenders
• Patience and time

Before You Begin…

Homeowners can start saving money at any time. But once they’re ready to begin planning a renovation, they may want to get several estimates of how much their desired renovation will cost. This means that before they start making inquiries about home improvement financing and reaching out to home renovation lenders, they’ll likely need to map out their plans first. Once they have a firm idea of what their renovation project will entail, they can then meet with several different home renovation contractors and get specific, written quotes for the job, including material costs, labor costs, and areas where cost overruns could potentially occur, as well as the costs associated with obtaining permits, preparation, and cleanup.

With these quotes in hand, homeowners will be able to make smarter choices as they determine how to cover home improvement costs. They may want to consider all of the financing options available to them, including loans for home improvement, additional mortgages, lines of credit, and drawing on the equity that exists in their home. To compare these options, homeowners will need to be comfortable examining how renovation loan interest rates and payments will affect the total cost of the project. It can also be important to consider the renovation timeline: How long do they have to save for the project if they don’t plan on financing it? If the property is in poor condition or the cost to make renovations to bring it in line with the homeowner’s needs is extremely high, then they may have to make a decision between remodeling or moving to a new home. For instance, adding a second floor to a single-story bungalow can be very expensive and will require a long construction process. In that case, it may make more sense to simply move to a house that already has all of the space the homeowner wants.

Tips for Paying for Home Renovations

• Be realistic about how high the costs might go. Assuming the best-case scenario could lead to a half-finished job or bills homeowners can’t afford to pay.
• Be willing to research all of the options before making a choice, potentially at different financial institutions.

STEP 1: Save money to pay for home renovations outright.

The first option, and for some people the best, is to pay for renovations in cash. Doing so may mean it will delay starting the project while homeowners patiently save, but there are several benefits to using cash. First, it’s great for small local contractors since they don’t have to absorb credit card fees or wait for disbursements from a loan or line of credit. Second, it ensures that the homeowner won’t be saddled with debt that might become a burden to repay. For instance, using cash forces hard decisions about whether homeowners can afford a fancy imported tile or if they should go with the less expensive (but still lovely) basic option.

It’s also important for homeowners to take stock of the whole financial picture when using cash. For a homeowner to spend their entire savings on a home improvement project when other debts need to be paid off isn’t ideal, and emptying their bank account when their borrowing power is already stretched thin leaves no emergency fund. Furthermore, if a homeowner were to lose their job or suffer a serious illness shortly after the renovations are completed, there won’t be any backup to cover their expenses.

Photo: istockphoto.com

STEP 2: Research eligibility requirements for home improvement loans to see if you can qualify.

How does a renovation loan work? There are several different types of home improvement loans that can be used to pay for a renovation project, each with its own benefits and drawbacks. Many banks offer personal loans specifically designated for home improvement projects. These loans have eligibility requirements similar to those of any personal loan: a good credit score, proof of income, and manageable existing debt. Borrowers may also need to detail how the funds will be spent, such as providing a quote from a contractor outlining the project. Many banks offer customers the opportunity to prequalify for financing, which will allow the borrower to see how much they might qualify for with a home improvement loan. To get prequalified for a loan, borrowers may need to sign off on a credit check, but that’s not always the case. Until an actual application for the loan is filed, most banks and lenders will only do a soft credit check, which involves a quick review of the borrower’s credit report and will not negatively impact their credit score. With that in mind, it’s possible for borrowers to check with several lenders to see which offers the best rates and terms without damaging their credit.

Home improvement loans can be unsecured personal loans with a designated purpose, meaning that the borrower does not need to put their own assets forward as collateral. As a result, these types of home improvement loans can have higher interest rates than those secured by collateral such as the borrower’s home. It’s important to consider all of the fees and costs associated with a loan for home improvement projects: origination fees, closing costs, interest rates, APR, repayment period, prepayment fees (if applicable), and late fees. Borrowers may also want to ask about available discount options, such as a reduction in interest rate for signing up for automatic payments, loyalty discounts if the borrower has other accounts at the bank, or special local programs offered for home remodeling projects that improve energy efficiency or follow community green standards.

Once several prequalifications are in hand, borrowers can weigh each offer, being careful to compare each aspect of the loans to make sure they’re making a fair assessment and selecting the best home improvement loan. The total cost of each loan can help homeowners decide if obtaining a loan is the right option for them. The total cost can also be an eye-opener for homeowners who suddenly realize their plans are too financially ambitious, in which case it’s probably time to go back to the drawing board and scale back the project with some new quotes.

STEP 3: Consider taking out a home equity loan or a home equity line of credit (HELOC).

If the home has equity available—the homeowners have paid down a fairly significant amount of the mortgage, for instance, or the home’s market value has gone up in recent years—a home equity loan or line of credit could be a great option as financing for home improvements. Home equity reflects the homeowner’s actual ownership stake in the property, and it can be calculated by taking the difference between the home’s market value and the amount still owed on the mortgage. Home equity loan programs allow borrowers to take out a loan or open a line of credit against the stake they own and have paid off in their home, essentially using the value in the home as a form of collateral and borrowing against themselves. Using this type of loan also requires that the owner’s debt-to-income ratio (DTI ratio) is low enough, suggesting that the borrower can take on more debt. Eligibility requirements can vary by lender, so if this is an option, it can be a good idea for homeowners to shop around with several different lenders to find the best home equity loans with terms that suit their needs (consider institutions such as U.S. Bank or Flagstar Bank).

Kendall Meade, certified financial planner at SoFi, an online bank and personal finance company, suggests that homeowners consider the full financial impact of a home equity loan before taking on that debt. “In many cases, home equity can be the best option for financing home improvements because [a home equity loan] usually has a lower interest rate than non-secured loans,” she says. “However, interest rates are pretty high right now, so if you have the ability to pay for your repairs in cash or by selling investments, this may be a better option. If you are trying to make this decision, consider reaching out to a financial planner who can help you analyze what is best for your specific situation.”

A home equity loan is disbursed in a lump sum in cash, with a repayment term that often runs between 5 and 30 years. Borrowers will pay closing costs, fees, and interest on the loan, and terms will be set for repayment at the outset. A home equity line of credit offers a little more flexibility: Borrowers are approved for a certain amount of credit against their equity, and then have a set period of time during which they can withdraw funds as needed for any purpose. They’ll then have a second mortgage payment to make each month until the funds are repaid, with interest. The interest rate on a HELOC is often variable, which can be a benefit or a drawback, as rates may go up or down over the course of the repayment period, but the interest paid is based on only the money that has been withdrawn, not on the whole amount approved. If the equity is available and the borrower’s DTI is low, a line of credit from one of the best HELOC lenders could be another economical and flexible way for homeowners to pay for a home renovation project.

Photo: istockphoto.com

STEP 4: Alternatively, tap into your home’s equity with a cash-out refinance.

For some people, the open line of credit may feel like an invitation to spend more than they want to, and a second mortgage payment every month makes a home equity loan or HELOC unappealing. Another option is to refinance their existing mortgage for the home’s current market value and then take the difference between the value and the amount left on the existing mortgage in cash. This is known as a cash-out refinance, and if homeowners go with one of the best mortgage refinance companies, it can be a great way for them to tap into their equity, particularly if they also want to adjust the terms of their home loan.

For instance, if a borrower wants to refinance a home that’s worth $300,000 on the market and they still owe $150,000 on their mortgage, that means there is $150,000 in home equity. It’s worth noting that lenders often require borrowers to leave a certain amount of equity in the property—20 percent, for instance. Depending on the homeowner’s credit score, DTI ratio, and a few other factors, the homeowner could potentially refinance the home with a $300,000 mortgage. The new mortgage would pay off the old one, and the remaining $150,000 could be returned to the homeowner in cash to finance the renovation. However, if the borrower is required to maintain at least 20 percent equity in their home ($60,000 in this case), then they could expect to receive up to $90,000 in cash to put toward their renovation.

If the renovation doesn’t use up the funds, the homeowner will have the option to use the remaining money for another project, or they can use it to pay down the new mortgage faster. A cash-out refinance does incur closing costs, which can chip away at the amount of funds available, but lenders may allow borrowers to roll those costs into their new mortgage. Cash-out refinance options are often best suited for homeowners who plan to remain in the home for quite some time, as they will extend the payoff date for the initial mortgage and increase the total mortgage amount, so a longer stay in the home will make the cost more worthwhile.

STEP 5: Use low-interest or 0 percent interest credit cards for lower-cost renovations.

Credit cards can be a convenient way to pay for a home renovation, and they have the benefit of incurring interest on only the money that has been spent. Additionally, credit card holders who pay their bills in full and on time can avoid paying interest entirely. Unfortunately, the interest rate on most credit cards is considerably higher than the rates on home equity loans, HELOCs, and personal home renovation loans. Homeowners who have outstanding credit scores may qualify for very low-interest or balance transfer cards that have low or 0 percent interest rates. Homeowners who are confident that they can pay off most of the debt within a certain period can consider cards that have an introductory 0 percent interest rate, then transfer any remaining balance to another low-interest credit card.

This can be a risky game to play for those on a tight budget, because if something unforeseen occurs, such as a job loss or illness, credit card holders can be stuck with a large balance on a card whose interest rate is about to jump up and have little recourse. Because of these concerns, homeowners may want to consider using this approach only for smaller renovations that could be paid off fairly quickly if necessary.

“Financing renovations with a credit card can be tricky,” Meade says. “It can cause you to pay a lot of interest. However, in certain circumstances, it may make sense. There are two instances that I can see it making sense: one, you have an emergency repair that must be made and have no better financing options, and two, you have a 0 percent or low-interest rate introductory offer for a time period and you will be able to pay off the credit card in full before that offer expires.”

STEP 6: Check to see if you’re eligible for any government home improvement loans.

Understanding that keeping properties in good condition enhances their value and preserves homeownership rates, the United States government backs several loan programs that are specifically designed to finance partial or total home improvement projects. Renovation loan requirements are specific, so it’s important to read the guidelines closely or work with an agent who understands the options.

• FHA 203(k) loans: Those who are purchasing or refinancing a home that they know will need immediate renovation can take advantage of the FHA 203(k) loan program, which allows buyers to increase mortgage amounts to include planned renovations.
• VA cash-out refinance: Eligible service members and veterans can take VA cash-out refinancing loans with all of the benefits afforded to original VA loans, including favorable terms and low interest rates.
• USDA repair loans and grants: The United States Department of Agriculture (USDA) offers single-family housing repair loans and grants to improve and modernize qualifying properties. Loans are available for up to $40,000 to low-income homeowners in designated rural areas for property upkeep and home repair services at 1 percent interest with repayment periods of up to 20 years. Grants are available to borrowers over age 62. Fannie Mae offers a similar program called the HomeStyle Renovation mortgage, but that program has some additional restrictions: The contractors who perform the renovations must be approved by Fannie Mae, which may limit the options.

Individual states may have other financing programs available for different groups of homeowners, so it may be worth investigating all possible options to find the best financing terms matching a homeowner’s needs.

Renovations can be exciting, but house remodel costs are a stressful burden for many homeowners. Mapping out a plan to pay for them before embarking on renovation projects and planning carefully to include the inevitable cost overruns and surprises (homeowners never know what they’ll find once contractors start poking around in electrical boxes, cabinets, ceilings, and subfloors) can make the process affordable and organized. These options, individually or in combination, allow homeowners to pay for their renovations all at once or over time without diving deeply into debt.