The Right Way to Finance Home Improvements

Paying cash is the best way to finance home improvements, but not everyone can do that. Rather than waiting until you are too old to care about the home, consider these options for your home renovations.

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Financing Home Improvements With Collateral

The following financing options for home improvements use your home as collateral. This means if you don’t make your payments, you put your home at risk. Keep this in mind as you consider taking out a new mortgage or refinance an existing one for a larger amount.

Use a Cash Out Refinance

If you have equity in your home, you are in the best position. You can use that equity to invest right back into your home. As an added benefit, you might even save some money.

Refinancing when rates are lower than your current rate can help you. Not only can you cash into your equity, but you can secure a lower rate. If you are lucky, your monthly payment won’t be that much higher than your original mortgage.

Even if rates aren’t lower, the cash-out refinance usually provides the lowest rates. Because it’s a first mortgage, the lender has first lien. If you default, this lender gets the proceeds of the sale first. In order to qualify, though, you must have a decent amount of equity. Most lenders don’t allow a cash-out refinance for more than 80% of the home’s value.

Take Out a Line of Credit

Maybe you don’t want to touch your first mortgage because you have a great rate. You might also want access to a credit line, rather than one lump sum of cash. In this case, you’d do better with a home equity line of credit.

You will still only be able to borrow around 80% of the home’s value minus the amount of your first mortgage. But, the line of credit has a benefit. You can keep reusing the funds until the draw period ends. Most HELOCs have a 10-year draw period. Think of it like a credit card.

You use your funds to make home renovations. Over the next 2 years or so, you pay the money back that you borrowed. You then have the money to use again, should you need it. You can keep doing this for the first 10 years. After that, the loan becomes closed.

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A benefit of the HELOC is the minimum required payment upfront. During the draw period, you only have to make interest payments. With the cash-out refinance, you’d pay principal and interest. While you might save money, there’s a downside to paying just interest. You never pay the principal down. This means you pay more interest in the long run.

Apply for a Second Mortgage

If you don’t like the accessibility of funds the HELOC offers, consider a 2nd mortgage. This is a closed-end mortgage, much like your 1stmortgage. You can find lenders that will provide loans with LTVS up to 85% sometimes.

Because this mortgage takes 2nd lien position, the interest rate will likely be higher. Borrowers that don’t want to lose the low interest rate on their first mortgage, use this option. With the 2nd mortgage, you receive your funds in one lump sum. You then make regular principal and interest payments right away.

A plus side to the closed-end loan is you can usually write off 100% of the interest you pay. This is especially true if you use the funds for home improvements.

Miscellaneous Ways to Pay for Home Improvements

If you don’t want to put your home at risk, there are a few ways you can finance your home repairs without collateral.

  • Take out a personal loan – Some banks offer personal loans for a few thousand dollars. Keep in mind, though, you’ll like pay more interest on this loan. Without your home as collateral, the bank has nothing to fall back on. They charge more for this risk.
  • Apply for a credit card – You may be able to secure a credit card for the cost of your home renovations. Again, you’ll likely pay much higher interest on this loan, though. Make sure you can afford to pay it off quickly. The longer you borrow the money, the more interest you pay.

If you can afford it, paying cash for your home renovations is usually best. This way you don’t worry about interest or higher mortgage payments. Of course, this is often hard to accomplish.

The best thing to do is figure out which option is the most affordable. You don’t want to get in over your head, but you want your home renovations. Compare the mortgage options you have and see which costs the least now and over the long-term. Talk to your tax advisor about the options that benefit you at tax time the most as well.

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