Considering a refinance mortgage for home improvements? If so, you’re not alone. More than 60% of Americans worked on home improvement projects in 2020, and much of that was funded by over $2.8 trillion in refinancing.
Homes need care to survive the damages of weather and time, and your family’s needs grow and change over the life of your home. But renovation and home repairs can be high-dollar projects that require a plan for how to pay for them without draining your savings account.
Are you familiar with a home renovation loan? If you are, a cash out refinance for home improvements is a popular renovation loan option, but you need to understand the pros and cons before deciding how to pay for your upgrades and repairs.
Can You Use a Cash Out Refinance for Home Improvements?
You can use a cash out refinance for any type of home improvement—and for anything else you want. There are no limits on how you use the cash you receive from this type of refinancing.
Although home improvement is a common use, some people use cash out refinancing to pay for:
- Medical expenses
- A new business venture
- High-interest loans and credit card
But before cashing in on your home equity, it’s important to consider the way a refinance will affect your long-term financial health.
How Does a Cash Out Refinance Work?
If you have a mortgage on your home, you’re probably used to getting refinance offers in the mail. One of the most common reasons to refinance a home is to get a lower interest rate, which often translates to a lower monthly payment.
With a traditional type of mortgage refinance, you’re simply trading in your current mortgage for a new loan of the same amount, but at a lower interest rate. In contrast, a cash out refinance to buy a second home or for home improvements allows you to add on an extra amount of money to your new mortgage so that you receive cash back when the loan closes. You can only use a cash out refinance if you have sufficient equity built up in your home.
Because you’re adding to your loan amount, there are more variables at play in the overall financial puzzle. Consider these elements to determine whether a refinance is worth it for you:
- Payments – Monthly payment could be either higher, lower, or stay the same.
- Mortgage length – A new loan comes with a new loan term (often 30 years, like a traditional mortgage). This usually means owning your home free and clear would happen at an older age.
How Much Can I Borrow With a Cash Out Refinance?
The amount you can borrow depends on your home’s equity. If you were refinancing with no cash back, you would simply be arranging a loan for the remainder of what you owe on your house.
With a cash out refinance, you are borrowing a total of the amount you still owe on your home plus a percentage of your home equity. Here are some steps on how to do a cash out refinance and figure out what you can borrow:
- Estimate the current value of your home. Although you may see an amount on your annual property tax valuation statement, this assessment is generally lower than true market value. As alternatives, you can:
- Use a free online valuation tool for a quick estimate
- Consult a real estate agent
- Hire a professional appraiser
- Determine home equity. Look up how much you still owe on your current mortgage(s) (and on any liens on the property). Subtract that from your home’s current value. This is your home equity.
- You can borrow up to 80% of your home equity. Multiply your home equity by 0.8 to determine this dollar amount. Although some lenders may stretch this to 90% depending on your credit history and income, 80% is common as a cap on equity.
But while you can use a cash out refinance to liquidate much of your home equity and make home improvements, that doesn’t mean you should.
Know the Costs
Whether you’re tackling home improvement to increase your home’s comfort or to boost curb appeal and sale price before you put it on the market, knowing how much your project will change your equity is an important financial consideration.
As any realtor will tell you, different types of remodeling can pay off at different levels. For instance:
- A major kitchen remodel recoups 53 – 58% of the cost
- Replacing outdated windows with vinyl recoups 72%
- Garage door replacement recoups 94%
Notice that none of these improvements recoup 100% of the cost, meaning that your remodel may not raise your home’s equity by enough to make the investment worth it.
Of course, your dream home is more than a black-and-white investment. It may be a family gathering place, a showplace for your passions and hobbies, or the place where you work, play, and love. Take all of your values and goals into consideration when deciding how to renovate, repair, or expand your house.
Should You Cash Out Refinance for Home Improvements?
To answer “should I refinance for home improvements or choose HELOC for home improvement,” you need to gather some information, including:
- Your credit score
- Your home’s current value
- The amount of equity you own in your home
- How much your interest rate could change (your rate now vs. current mortgage rates)
- The estimated change in equity or resale value from the planned project(s)
- How long do you plan to stay in the house (and if there is a risk of an unexpected move)
Let’s take a look at the pros and cons of this type of funding to improve your home.
Pros to Cash Out Refinancing
Some of the benefits to choosing a cash out refinance are:
- Low rates – Mortgages have a lower interest rate than personal loans. Plus, mortgage rates are trending low enough that there’s a good chance of lowering your current interest rate and your monthly payments.
- Tax breaks – A refinance for home improvement can provide a tax deduction, but only on the amount used to substantially improve your home.
Cons to Cash Out Refinancing
Although it seems tempting to get a pile of “cash back” from a transaction, there are downsides to a cash out refinance, such as:
- Increased foreclosure risk – A mortgage is a secured loan that uses the property as collateral. If you default on payments, the lender can take possession of the house. If you are at all at risk of losing your ability to make mortgage payments on a higher loan (your mortgage plus the cash you take out), then cash out refinance can be a dangerous financial move.
- Closing costs – Unlike a home equity loan or home equity line of credit (HELOC loan), a cash out mortgage comes with closing costs of 3-6% of the loan amount. If you aren’t also acquiring savings through a lower mortgage rate or basing your home improvement on adding to the value of your house, this could be a hefty fee for what is essentially a home improvement personal loan.
- Private mortgage insurance – PMI is generally required on a mortgage when a homeowner has less than 20% of the home’s equity. If you hit that 80% cash out level, you may end up with the added fee of PMI, which can be an annual cost of up to 2.25% of your loan total.
- Loss of equity – Opting for cash out refinancing means you are essentially selling your home’s equity. If you end up having to move or sell your home, this means you would see a lower profit on the sale or even end up owing on your mortgage after selling the home.
- Limited availability – Most lenders are looking for a minimum credit score over 620 to qualify for a cash out refinance, and your exact score will be part of calculating your interest rate offer.
A Better Way for Homeowners to Finance Home Improvements
If you’re looking for a more flexible way to stay in your home while improving it, there are other options like a home renovation loan or home equity loan alternative. Both are alternatives to doing a refinance to remodel.
Whether you don’t meet the credit score or equity levels or want to avoid tying yourself to more years of mortgage payments and obligations, you have options.
A sale-leaseback solution may be able to help you reach your goals. A sale-leaseback solution allows you to sell your home, convert your home’s equity to cash, and lease your home back for as long as you need. You can utilize the cash to improve your home in the mean time and buy back the home when you’re ready.
Are you familiar with a home renovation loan? If you are, a cash out refinance for home improvements is a popular renovation loan option, but you need to understand the pros and cons before deciding how to pay for your upgrades and repairs. If you are still unsure of alternative options to refinancing after reading this article, consult a financial advisor to discuss your options.
- NerdWallet. Looking to Fund a Remodel? Consider a Renovation Refinance. https://www.nerdwallet.com/article/mortgages/renovation-refinance-loan
- Wall Street Journal. Cash-Out Refinancings Hit Highest Level Since Financial Crisis. https://www.wsj.com/articles/cash-out-refinancings-hit-highest-level-since-financial-crisis-11615458602
- NerdWallet. Cash-Out Refinance Pros and Cons. https://www.nerdwallet.com/article/mortgages/refinance-cash-out
- NextAdvisor. Why Refinancing Might Be Your Best Option to Fund Home Improvements Right Now. https://time.com/nextadvisor/mortgages/refinance/home-improvement-refinance/
- U.S. News. What’s the Difference Between Your Home’s Market and Assessed Value? https://realestate.usnews.com/real-estate/articles/whats-the-difference-between-your-homes-market-and-assessed-value
- Investopedia. How Do I Calculate How Much Home Equity I Have? https://www.investopedia.com/ask/answers/070715/how-do-i-calculate-how-much-home-equity-i-have.asp
- Remodeling. 2020 Cost vs. Value Report. https://www.remodeling.hw.net/cost-vs-value/2020/
- Credible. Should You Refinance to Pay for Home Improvements? https://www.credible.com/blog/mortgages/refinance-for-home-improvement/