Is refinancing for home improvement right for you?

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This year, there’s one place you’ve been spending a lot of time in: your home. Between shelter-in-place orders and work-from-home policies, you’ve likely had plenty of time to reflect on how you can make your home feel more comfortable.

If you’re considering doing renovations, now’s the time to explore how refinancing can help pay for them.

How refinancing for home improvement works

Before you start comparing your options for refinance and renovate loans, you’ll want to have a good estimate of the cost of the project. 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’ve decided 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 cash-out refinance, most lenders limit the LTV ratio to 80 percent.

Your new mortgage now has different terms, different monthly payments and a different interest rate — sometimes higher than what you had originally — and you now have 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’ll get the money you need to upgrade your home by using the equity you already have.
  • Upgrades can translate to an uptick in value – If the renovation is a success, the improvements could increase the value of your property.
  • Tax deduction – The renovation can 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.

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.
  • 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.

Cash-out refinance requirements

The news of record-setting mortgage rates may be part of why you’re wondering whether refinancing for home improvement is a good move, but it’s important to note that qualifying for those cheap borrowing opportunities is not automatic. You’ll want to have a concrete understanding of your LTV ratio before submitting an application to a lender.

“Depending on how much of an equity cushion you have, some lenders might not approve it,” McBride says. “Others will put such a markup on the rate that you’re not going to lock in any of the record-low rates that attracted you in the first place.”

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.

“In this environment, you need to have a fairly substantial amount of equity in your home to do a cash-out refinance and not pay a punitive price for doing so,” McBride says.

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.

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.”

Qualifying for a HELOC today is no easy feat, either. Chase and Wells Fargo both stopped offering HELOCs this spring. According to McBride, credit has gotten much tighter this year, as no one is sure what to expect from the defaults and delinquencies from the COVID-19 financial fallout.

“Lenders have frozen and cut existing credit lines, and some have stopped offering new home equity lines of credit altogether,” McBride says.

If you can get approved for a HELOC, though, there are some pros and cons to consider. The 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.”

The final step prior to getting the funds from either a cash-out refinance or HELOC comes with a key difference that makes a HELOC definitely a winner.

“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.

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