5 Ways to Finance a Home Renovation
While spending quite a bit of time in our homes over the last 18 months, have you found yourself looking around and thinking about some home renovation projects? A little DIY, if you will? Some of my clients have found themselves making makeshift home offices, kid workspaces, and even deciding to finally tackle the full kitchen remodel they had been putting off for so long! As homeowners, upkeep and regular maintenance aren’t usually items we need to budget for but a full renovation project may require a larger budget. Fortunately, there are a few options available depending on your exact scenario. Here are the top 5 ways to finance your upcoming home renovation!
Paying cash for a home renovation is a simple concept but not always as simple to do. Essentially you save up until you have enough in the bank to pay for the project as it’s completed. The positive is there’s no interest to be paid like there is with a loan. For small projects like a new sink or light fixture, paying cash may make the most sense but for larger projects it may be more difficult especially as things always tend to come up when doing projects, which can change the estimated amount of the project very quickly.
2. Retirement Accounts i.e. 401K and IRA
If you have a good amount set aside in a retirement account such as a 401K or IRA and you aren’t looking to retire soon, you can withdraw cash from one of these sources. However, you will want to keep in mind that there will potentially be tax implications and, typically, penalties incurred. In addition, using 401K or similar funds to finance home renovations also reduces the amount of savings you'll have available at retirement.
3. Home Equity Line Of Credit (HELOC)
A home equity line of credit (HELOC) gives you the ability to pull out cash from the equity you have in your current home. Most lenders allow you to borrow 85% of the equity you have based on an appraised value of your home and how much you owe on the mortgage. For example: the appraised value of your home is $500,000 and you owe $400,000 on your mortgage. You currently have about $100,000 in equity. Multiple that $100,000 by 85% and you could potentially get $85,000 for your HELOC amount. You don’t necessarily need to pull that full amount if it’s not needed but that would be the maximum you’re able to access. With this option, your primary monthly mortgage would stay the same and then the HELOC loan would be placed as a second lien on your home (behind your primary loan). Essentially this second amount is a revolving source of funds similar to a credit card.
Most HELOCs have two phases: a draw phase and a repayment phase. During the draw phase, you're eligible to access the funds and you will likely only be required to make small, interest-only payments. After the draw period ends, the loan enters the repayment phase. Usually during the repayment phase, you can no longer access additional funds and are also required to make regular principal plus interest payments until the amount you borrowed has been fully repaid.
A quick item to be mindful of with this option is that the interest rate associated with a home equity line of credit will fluctuate depending on current market conditions so it’s great for having access to funds as needed but for large projects that could take a lot of time, it may not be the best option.
4. Cash-Out Refinance
A cash-out refinance provides you with a specific amount for the renovation that is then rolled into a new mortgage total during a refinance. Let’s break it down using the same scenario as #3. For example: the appraised value of your home is $500,000 and you owe $400,000 on your mortgage. You currently have about $100,000 in equity. Now let’s say your project requires $50,000. With a cash-out refinance, your original $400,000 mortgage is paid off and a new mortgage of $450,000 (original $400,000 + $50,000 for project) is put in place. Now you are making monthly payments based off the new mortgage amount and have the cash on hand for expenditures.
A few key items to keep in mind with this option: as outlined above, it will increase your mortgage balance and monthly amount but has a set interest rate that is typically lower than a HELOC rate and doesn’t change with market conditions. Also, you do pay for the refinance so it may be a little more expensive due to closing costs.
5. Renovation financing
For homeowners who currently have very little equity in their home, renovation financing might be the best option. It has similar qualities to a cash-out refinance but they do the analysis based on the FUTURE value after the renovation is complete instead of the current value of the home. That way the renovation cost is bundled into the new higher mortgage and the lender pays the contractors as the work is completed in order to ensure they are getting paid and know the costs associated. Essentially, renovation financing helps a homeowner improve the value of their home and spread the amount through their mortgage over the course of the loan. The biggest item on this option is to really make sure the value is going to increase by a minimum of the amount that it will cost for the renovation.