Improving your home not only makes it look better but also increases its sale value. It increases the functionality of your home and also gives personal satisfaction. But it comes at unexpected costs, and any available resources may not be enough. So, it is advisable not to risk your savings and, rather than taking out a second loan, consider opting for refinancing. The best way to refinance for home improvement is to choose a cash-out refinance option.
Cash-out refinance is best only when you have built equity in your home. As per the general rule of thumb, you must have 20% equity in your home to refinance. It allows you to replace your existing mortgage with a new mortgage amount and gives you access to funds for your project.
If you’ve decided to refinance your home for renovations, this blog will help you explore the cash-out refinance option and other alternatives, too.
Benefits of a Home Renovation
A home renovation can give your home a fresh look. Whether you plan to sell the house or stay there for years, a renovation can offer several advantages. Here are a few benefits that a home renovation offers -
Return on Investment
The kitchen and bathroom are high-traffic areas that make the overall home attractive to potential buyers. A renovation can boost the functionality and convenience, which often contributes to your home’s resale value.
Prevent Further Damage
While repair can be costly, it can be more expensive if the damage expands. For example, if you leave your damaged roof neglected, it can lead to damage to your walls, ceilings, or even your home’s structure.
Enhance Your Living Experience
Your home is one of your biggest assets and investments. Adding features that improve the aesthetics and functionality of your home can make it more comfortable and enjoyable.
Create More Space
As your family grows, you will need a larger space. Hence, renovation helps you add new bedrooms, bathrooms, or even expand your living areas. Thus, accommodating your family without discomfort.
Best Way to Refinance to Pay for Your Home Improvements
The best way to refinance your home improvement plans is with a cash-out refinance strategy. It is a suitable option for those who are looking to finance their renovation while potentially benefiting from lower interest rates. Here’s an example below that showcases why it is an ideal choice -
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Current mortgage balance: $300,000
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New mortgage amount: $340,000
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Cash withdrawn: $40,000
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Purpose: Use cash to remodel any part of the house.
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Benefit: Improve the space and possibly increase the home value.
Using a cash-out refinance, you can replace your old mortgage with a new one. Though your monthly payment may increase slightly, the renovation of the home can potentially increase its value at the time of resale.
What Are the Pros and Cons of Using Cash-Out Refinance?
Here are some pros and cons of using the cash-out refinance option -
Pros
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Easy Access to Cash: You can obtain funds to cover major expenses like education, home improvement, investment, or debt consolidation.
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Lower Rates Of Interest: Cash-out refinancing usually offers a lower interest rate than personal loans or credit cards. Thus, helping you save more in the long run.
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Tax Benefits: Sometimes, the interest paid on the new mortgage may be tax-deductible, especially if the funds are used for home improvements.
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Increased Value of Home: Using the funds to improve the appeal of the home can increase its value, potentially leading to a higher resale value.
Cons
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Closing Costs: As with a mortgage loan, a cash-out refinance generally includes closing costs, such as appraisal fees, loan origination fees, and title insurance.
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Increased Loan Balance: A cash-out refinance increases your mortgage amount. This can extend the loan term and result in higher total interest payments over time.
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Reduction in Home Equity: Accessing your home’s equity through a cash-out refinance can lower the equity you hold. While future renovations may boost your property’s value, you’ll experience a short-term loss in equity, which may pose a risk if the value of the property drops. Thus, resulting in minimal or negative equity, where the loan balance exceeds the market value of your home.
Steps to Refinance for Home Improvement
Here is a step-by-step guide on how you refinance for your home improvement -
Identify Your Home’s Current Market Value and Mortgage Balance
You can schedule a home appraisal to determine your market value. This will help you know how much equity you have. For example, if you owe $70,000 on a house appraised at $250,000 and want to build an in-law apartment, you could opt for a cash-out refinance.
This would allow you to take out a new mortgage of up to $200,000, which is enough to pay off the existing $70,000 loan and leave you with $130,000 for renovations. But why $200,000? Because it maintains an 80% loan-to-value (LTV) ratio based on your home’s current value.
Determine the Loan Amount
You can request home improvement estimates to understand how much loan amount you would need. This will help you ensure that you don’t fall into more debt than needed.
Research the Loan Option
Before proceeding, consider researching your options with several lenders. This will help you find the most suitable loan option. Once you determine the lender you want to move forward with, you can discuss your goals and estimated home value to find the most suitable loan.
Apply for the Loan
Gather all the information you have regarding your assets and income. The lenders will check your credit score and existing debt to determine your repayment ability. Once you’re qualified, you need to pay closing costs and sign the paperwork.
Proceed With Renovations and Improvements
After closing the loan, you’ll have the funds within 3 business days. Once you have the loan amount, you can begin with the renovation.
Begin the Loan Repayment
Once you have started the renovation, you’ll have to begin making monthly payments on the new loan, which covers both your original mortgage balance and cash-out amount. This new mortgage will have updated terms, which may include a higher rate of interest and increased monthly payments compared to your previous loan.
How to Qualify for a Cash-Out Refinance?
Refinance helps replace your current mortgage with a new one. This means you must meet the same standards as purchasing a loan, even if you apply with the same lender as your current mortgage. Here are the qualification criteria you need to meet for a cash-out refinance -
Loan-To-Value Ratio (LTV)
Lenders usually set a limitation on the amount you can borrow through a cash-out refinance. For conventional loans, the cap is usually 80% of the home’s appraised value. However, some loans may also permit homeowners to refinance up to 90% of their property value.
Credit Score
A credit score is categorized as “good” or “excellent. As per FICO (Fair Isaac Corporation), a “good” credit score is 670 or higher. Some loan types may also have minimal credit requirements. For example, a standard benchmark for VA Cash-Out Refinance is 620.
Debt-To-Income Ratio (DTV)
Your DTI ratio may vary with the lender, indicating the percentage of your gross monthly income that goes toward paying debts.
What Can You Use the Cash for?
You can use the cash for anything you want. But, it is also important to remember that not all home renovations deliver the same return on investment. Hence, it is advisable to prioritize upgrades that can add value to the property. Kitchens are considered the focal point of the house, which makes them the smartest place to invest. Even modest kitchen updates can significantly increase your home’s appeal.
As per Remodeling magazine, the average national ROI for a minor kitchen remodel in 2024 was approximately 96.1%. Additionally, bathrooms can be a great option for upgrading, as they, too, yield strong returns, with a mid-range renovation delivering an average ROI of 73.7%.
What Are Some Alternatives to Refinancing Your Home Improvement?
If you’re not ready for a cash-out refinance, there are many other alternatives you can opt for. Here are the 5 best alternatives that you can explore -
Energy-Efficient Loans
Energy-efficient mortgages (EEMs) give buyers the ability to include the cost of energy-saving upgrades in their home purchase financing. While these loans are less frequently used for refinancing, some lenders do allow them in combination with other products.
Renovation Loans
Loan options, such as VA Rehab Loan, FHA 203(k) Loan, and Fannie Mae HomeStyle Loan, are designed to cover both the purchase or refinance of a home along with the cost of necessary repairs or upgrades. These loans are best for buyers or homeowners who may not have substantial savings or equity available to fund renovations.
Personal Loans
A personal loan can be a versatile financing tool for home improvements. These loans usually have a fixed interest rate and a set repayment term, which makes them easy to plan for financially. They are often suitable for smaller-scale renovations or for those without considerable home equity.
Home Equity Loans
With home equity loans, you borrow a one-time lump sum based on your home’s equity. It works as a second mortgage and usually features a fixed interest rate and terms, which offer predictable monthly payments.
Home Equity Line of Credit (HELOC)
A HELOC offers you flexible access to funds by allowing you to borrow against the equity of your home, as required. Like a home equity loan, it is a second mortgage with a variable interest rate. You can draw funds during a particular draw period (commonly up to 10 years), followed by a repayment phase. Thus, allowing you to use only what you need.
Credit Cards
Credit cards usually have higher interest rates than any other borrowing options. But some cards come with 0% APR introductory periods, which are best for minor home projects. If you pay off the balance in full before the end of the given period, you don’t have to pay interest on your purchase.
Conclusion
If you’re deciding to refinance your home improvement and have enough equity built up, a cash-out refinance can be the best option. However, if you do not have enough equity, you still might be able to use a refinance loan to fund your renovation project. But whichever loan you choose, consider talking to several lenders about your options. This can save you thousands of dollars on your new loan and also reduce the overall cost of home improvement.
