After more than a year at home, we’ve had a lot of time to think about how our homes could be improved — an addition for a growing family, a big kitchen for cooking holiday meals, or an outdoor space you’ll want to spend time in every day.
At the same time, housing markets in many places have gotten really competitive, which means a lot of homeowners have built up equity fast.
If you’re thinking about a major home improvement project, consider using the equity you’ve built to pay for it. Cash-out refinancing and home equity loans put cash in your account right away, while home equity lines of credit give you access to a revolving source of funds that you can tap throughout your renovation.
Lots of people who have mortgages have refinanced them in the last few years to take advantage of low interest rates. That’s not the only benefit of refinancing, though: If your home has gained value since you bought it, you can take advantage of your equity with cash-out refinancing.
For example, let’s say your home is worth $300,000 and you owe $150,000 on your mortgage. The difference between what you owe and the value of your home — in this case, $150,000 — is how much equity you have.
When you refinance your home, you replace your current mortgage with a new one. Usually, the amount you owe stays the same, but the interest rate or loan term changes.
When you do a cash-out refinance, however, you increase the mortgage balance and receive the difference as cash. You’ll pay the lender back over time as part of your mortgage. If you did a cash-out refinance on our example home, you could increase the amount of your mortgage balance to $200,000. The lender would pay you $50,000 — the difference between your current balance and your new one — up front, and you’d pay back a total of $200,000 over the life of the loan.
You can usually borrow up to 80% of the value of your home. If you have a lot of equity in your home, a cash-out refinance could allow you to borrow a significant amount of money at a low interest rate. Remember too that if your renovation increases the home’s value significantly, you might be able to deduct the mortgage interest on your taxes.
Taking Out A Home Equity Loan or HELOC
One of the most common ways to finance a big home renovation is to take out a loan that uses the value of your house as collateral. There are two ways to do this: A home equity loan, which is a lump sum of cash that you pay back over time; and a home equity line of credit, which works more like a credit card.
Let’s start with home equity loans. These loans are also called “second mortgages” because they work almost the same way — the bank pays you a lump sum of money and you agree to pay it back over time with interest. The interest rates are usually fixed and are comparable to those of mortgages. Payments are fixed, so you know exactly how much you’ll owe each month over the life of the loan.
Home equity loan terms usually range from five to 20 years. You’ll probably have to pay closing costs. Some lenders also require borrowers to pre-pay some of the interest ahead of time, called “points.”
A home equity line of credit (HELOC) is another way to borrow against the value of your home. With a HELOC, though, you don’t receive a lump sum of cash all at once. Instead, you have access to a line of credit — a source of funds that you can borrow against at any time.
HELOCs are more like credit cards than mortgages. Borrowers usually don’t have to pay closing costs (or if they do, it’s usually minimal). Interest rates usually vary on this line of credit. You can borrow funds when you need them and pay them back as you’re able. Like credit cards, HELOCs have credit limits, and you owe interest on what you’ve borrowed until you’ve paid it back.
HELOCs include a “draw period,” in which you can borrow funds and, in some cases, make interest-only payments. Everything you borrow, plus interest, must be repaid by the end of the “repayment period.” Make sure you know the terms and details of how your HELOC works because they vary from lender to lender.
If you take out either type of loan, remember that borrowing against the value of your home can be risky. When you take out a home equity loan or a HELOC, the bank puts a lien on your home, which means that if you stop making payments, they can take possession of the property. And like a mortgage, you can end up underwater — owing more on the loan than your home is worth — if home values take a sudden dive.
That said, home equity loans are a great option if you need a lump sum of cash for a specific project, like an addition or a major remodel, and you know approximately how much it will cost. HELOCs can be helpful if you’re not sure how much renovating you want to do or how much it will cost.
It’s OK To Start With Smaller Projects
If your renovation project is on the smaller side, you might be able to pay for it in cash. Use your tax refund (or savings you’ve built up during quarantine) to help defray the up-front costs. If you still haven’t touched the money you budgeted for 2020 travel, that could help too.
If you’re not quite sure how much a project will cost or how much you want to do at once, start by paying for a few small fixes in cash. You’ll get a feel for how renovations work and how much time and money you’ll need for bigger projects.