While strategic home improvements can potentially raise your home’s value, they come at a cost. If you’re considering doing renovations but don’t have the savings to cover the project, it’s worth exploring how refinancing can help pay for it.

How refinancing for home improvement works

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.If it’s a major upgrade, a cash-out refinance might make the most sense.

“There are a number of different avenues where a homeowner can tap into the money needed for a $20,000 renovation, but the big $100,000 renovation often necessitates a cash-out refinance,” explains Greg McBride, CFA, chief financial analyst at Bankrate.

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 $150,000, and you decide you want to completely gut your kitchen and bathroom.

With a cash-out refinance, you can get a mortgage up to $120,000, which would pay off the $70,000 debt and leave you with $50,000 (a bit less than that after closing costs) to use for the renovation. The $120,000 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 ($150,000). 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 — and give you the funds to pay for the renovation.

Cash-out refinance for home improvement: Pros and cons

Pros

Access to a big chunk of cash – The biggest upside of a cash-out refinance is that you get the money you need to upgrade your home by using the equity you already have.

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 – Renovations can also make a difference when you file your taxes. In general, you can deduct the interest you pay on the mortgage so long as you use the funds to make improvements that add value to the home. Improvements can also increase your tax basis in the house, which will reduce your capital gains tax liability when you sell.

Cons

You owe more – With a cash-out refinance, your overall debt load will increase. No matter how close you were to paying off your original mortgage, the extra cash you obtained to pay the contractor is now a bigger financial burden. This also reduces your proceeds if you were to sell.

Closing means paying – Just as you had to pay closing costs on your original mortgage, you’re going to need to pay similar expenses when you refinance. Those can be significant.

Unexpected tax implications – With a cash-out refinance, you’re taking on additional mortgage debt, which can have an adverse affect on your tax liability, so be sure to consult with your accountant.

Cash-out refinance requirements

  • A good or excellent credit score, typically 700-750 or higher
  • A low debt-to-income (DTI) ratio, usually 40 percent or less
  • A higher income
  • At least 20 percent equity

Despite rising rates, mortgages are still among the cheapest loans you can get — credit cards and personal loans cost much more. 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.

Cash-out refinance vs. home equity line of credit

One potential alternative to a cash-out refinance is a home equity line of credit, or HELOC, which can also help pay for renovations. 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 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.)

Still, with a HELOC, “you have to have a pretty healthy chunk of home equity,” McBride says. “You’re not going to find many lenders that are comfortable going above an 80 percent loan-to-value ratio.”

If you can get approved for a HELOC, there are some pros and cons to consider. Having access to a line of credit can tempt you to tap it for a short-term expense, such as a vacation or wedding, which you’ll be repaying for many years to come. The other drawback is that a HELOC has a higher rate than you’ll find in a refinancing scenario, and the rate can change.

“It’s variable,” McBride says, “so if it increases, you’re paying more.”

McBride notes there’s a benefit to the payment flexibility, though: “You can make interest-only payments, and accelerate payments at a time when you have more of a cushion.”

Note you might be able to get an interest-only HELOC, which means you’ll make only interest payments for a specified period of time. While these can be more affordable upfront, you’ll need to be prepared to refinance or pay off the full balance when it matures.

Using a HELOC also allows you to sidestep refinancing your entire mortgage balance at a new rate. That can save you a lot if you secured a lower rate than the current market rate. For this to work, you’ll need to be diligent about making your monthly principal and interest payments.

The final step prior to getting the funds from either a cash-out refinance or HELOC comes with a key difference that can make a HELOC a better option for you.

“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 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.”

Bottom line

A cash-out refinance can be a smart way to pay for home improvements and renovations, but you have to have adequate equity in your home, and ideally, want to find the lowest possible rate.

Before you start comparing refinance rates, make sure you know where you stand financially. You can use Bankrate’s loan-to-value ratio calculator to have a solid grasp on how much you owe on your existing mortgage. Then, you can add up the projected costs of your home renovation to see how much you need to turn your current home into your dream home.