Refinancing for home improvement: How it works

Strategic home improvements can substantially increase your home’s value (read: price tag at selling time), but they come at a cost. Often, a well-into-the-five-figures cost. If you don’t have the savings to cover the project — or don’t want to deplete them to do so — it’s worth exploring how refinancing your mortgage can help pay for it.

It can be a savvy financial move. But refinancing for home improvement has its risks, too. Let’s dig into the pros and cons.

How refinancing for home improvement works

Refinancing for home improvement involves a specific type of transaction, called cash-out refinancing. In a cash-out refinance (cash-out refi for short), you replace  your existing mortgage with a larger home loan, taking the difference out in cash.

A cash-out refinance leverages your home’s equity. Let’s say you owe $70,000 on your home, which has an appraised value of $250,000, and you decide you want to add an in-law apartment (a little home-within-the-home) to your residence.

With a cash-out refinance, you can get a new mortgage up to $200,000, which would pay off the $70,000 debt and leave you with $130,000 (a bit less than that after closing costs) to use for the renovation. The $200,000 keeps you within an 80-percent loan-to-value (LTV) ratio, meaning that the loan is equal to no more than 80 percent of the value of the home ($250,000). For a conventional cash-out refinance, most lenders limit the LTV ratio to 80 percent.

Your new mortgage will have different terms, possibly higher monthly payments and a different interest rate — sometimes higher than what you had originally.  You’d start repaying it in monthly installments, just as you did your old mortgage. Main difference: On closing day, the lender would give you the funds to pay for the renovation.

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Pros and cons of using a cash-out refinance for home improvements

Pros

• Access to a big chunk of cash: You can access the money to improve your home by tapping into your home — specifically, the home equity stake you’ve already built.

• Upgrades can translate to an uptick in value: Depending on the type of renovation, the improvements could increase the value of your property and further build your equity.

• Tax deduction: You can typically deduct your mortgage interest if you use the funds from your cash-out refinance to make improvements that increase your home’s value. Improvements can also boost your tax basis in the house, lowering your capital gains tax liability if you sell.

Cons

• You owe more: Your total mortgage debt will increase with a cash-out refinance. So if you were within a few years of paying off your original loan, the extra cash you borrowed for your home project will be a setback. It will also result in a smaller profit if you sell.

• Depleted home equity: With a cash-out refinance, you’re borrowing against your home equity, turning the amount you own into an amount you owe. You’ve diminished your outright ownership stake, in other words.

• Closing means paying: You’ll need to pay closing costs when you refinance like you did with your original mortgage loan. Though usually less than the first time ‘round, these costs can add up to around 2 to 3 percent of the loan amount.

How to qualify for a cash-out refinance

A cash-out refi is a new mortgage, so you will have to qualify, meeting the lender’s criteria — even if you’re using the lender of your original loan. Among the requirements:

• Good or excellent credit: A good or excellent credit score is typically 670 or higher.

• Low debt-to-income (DTI) ratio: Your DTI is your total monthly income relative to your total monthly debts. Ideally, lenders will want this number to be around 36 percent, though some will accept DTIs of 43 percent.

• Loan-to-value ratio: Most lenders require that you have an LTV ratio below 80 percent. To determine your LTV, divide your outstanding mortgage balance by the market value of your home, then convert that number to a percentage.

• Decent income: In addition to adequate home equity, you’ll also need consistent income to qualify for a cash-out refinance. Income requirements vary by lender.

Despite recent rate increases, mortgages are still among the cheapest loans you can get — credit cards and personal loans often have higher rates. However, you’ll want to have a concrete understanding of your LTV ratio before submitting an application to a lender.

Say you have an LTV ratio of 50 percent and do a cash-out refinance to pay for a renovation, and the new loan terms put your LTV ratio at 70 percent. That still looks good in the eyes of the lender, but, if you’ll wind up with an LTV ratio above 80 percent after you add on the cash, you may encounter some trouble.

Alternatives to refinancing for home improvements

A cash-out refi isn’t the only option for funding home improvements. There are other ways. Among them:

Home equity line of credit

One potential alternative way to pay for renovations is a home equity line of credit, or HELOC. While a cash-out refinance gives you a lump sum of money, a HELOC gives you a line of available credit, and you use whatever you actually need from that line to pay for the project.

HELOCs typically have variable rates, meaning the interest you pay can increase or decrease. They also come with a draw period — the time frame during which you can withdraw funds, typically 10 years — and a repayment period, the time you have to pay back the money and interest charges, typically 20 years. (This shorter amortization period means the HELOC payment will be higher than an equivalent cash-out refinance.)

You can repay the HELOC during the draw period too, though — and those repayments replenish the credit line, so you can borrow against them again. Greg McBride, chief financial analyst at Bankrate, notes there’s a benefit to the payment flexibility: “You can make interest-only payments, and accelerate payments at a time when you have more of a cushion.”

Since they’re withdraw-as-you-go, HELOCs can be ideal for long-term renovation projects, in which you often pay contractors at set intervals. Their revolving balance means you won’t be caught short if unexpected expenses or overruns occur. And you’re only charged interest on the amounts you actually withdraw.

Home equity loan

With a home equity loan, you’re also borrowing against the equity you’ve built up in your home. But instead of obtaining a line of credit as you would with a HELOC, you borrow a lump-sum amount (similar to the cash-out refi). For this reason, home equity loans are typically a better choice if you have a clear idea of how much you need to borrow.

Home equity loans usually come with fixed rates, and repayment terms may be as long as 30 years. As with a HELOC, closing costs may apply when you take out a home equity loan.

Personal loans

If you prefer not to borrow against your home equity at all, a personal loan is another option. Many lenders offer these loans, and you can generally get approved and funded more quickly than you would with a cash-out refinance, HELOC, or home equity loan.

The tradeoff is that personal loan interest rates tend to be higher and loan amounts may be smaller. Given this, these loans are typically better for those with excellent credit and less-expensive home projects.

Credit cards

Credit cards generally come with higher rates than any of the other borrowing options on our list. But there’s one exception you may want to consider if you have a minor home project planned — a 0% APR credit card.

These cards offer deferred interest for a set time period, usually 12 or 18 months, as long as you make your minimum monthly payments on time. After that, the credit card’s regular rate applies.

If you can meet your monthly debt obligations and pay off your balance during the introductory period, a credit card with a 0% introductory offer could be a smart choice.

Choosing the best option for your home improvement needs

To determine which financing option is best for your situation, it’s essential to compare different factors, including:

• Rates: Your interest rate will impact your total borrowing costs. Cash-out refi rates tend to be lower than those of home equity loans and HELOCs. However, using one of the latter two also allows you to sidestep refinancing your entire mortgage balance, which could be save you a lot if interest rates in general have risen since your original mortgage.

• Terms: Compare loan or credit line repayment terms, and select an option that best aligns with your budget. For instance, if you have a larger project planned, a longer term could help make your monthly payments more affordable, though you’ll likely pay more in interest over time.

• Closing costs or fees: “It’s important to think about the closing costs,” McBride says. “A cash-out refinance comes with closing costs just like a regular refinance. It will cost you a few thousand dollars whether you’re paying upfront or rolling it into the loan. Closing costs on a home equity line of credit [or home equity loan] are much more modest. You don’t have to go through the big expenses of title work, state and local taxes and other mortgage fees.”

• Amount you need to borrow: Your project costs will also factor into your decision. For a large, expensive project that totals tens of thousands of dollars, you may need to rely on a cash-out refinance, HELOC or home equity loan. (The latter two usually have a minimum of $10,000.)  But a personal loan or credit card could be suitable for a smaller project.

• Project timeline: If you need funding fast, a cash-out refinance, HELOC, or home equity loan probably isn’t the best choice. It can take several weeks to close on these loans. In comparison, a personal loan may be disbursed in a matter of days after approval.

Bottom line on refinancing for home improvement

Using your home to upgrade your home: not the worst idea in the world.  A cash-out refinance can be a smart way to pay for a substantial home improvement project. But you need sufficient equity in your home, and ideally, want to find the lowest possible rate.

Before you start comparing your options for refinancing and renovation loans, arrive at a good estimate of the cost (plus a margin) of your project. It’s best to get estimates from at least three contractors.

Next, know where you stand financially. You can use Bankrate’s loan-to-value ratio calculator to have a solid grasp on what you owe on your current mortgage, and a sense of how large a refi you could realistically do.

Finally, compare how much cash you could access with the projected costs of the remodel. If they are close, a cash-out refinance might make the most sense for turning your current home into your dream home.

Additional reporting by Jess Ullrich