You Can Pay for a Home Renovation With These Loans. But Should You?

Photo to accompany story about using mortgage loans to pay for home renovations. Getty Images

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Is it working from home, or living at work? 

With offices remaining virtual and classrooms going online, more and more Americans are using their homes as their productivity center. According to a Stanford University study, 42% of Americans are doing their job remotely  – some for the first time ever. 

Spending so much time at home is making many people reconsider how the places where they live look, and what they can do to improve the great indoors. A 2020 study by real estate site Trulia found 90% of Americans planned home renovations this year, with one in five willing to spend up to $10,000 or more. 

Refurbishing outdoor spaces is top of mind for many homeowners, too, according to real estate agents who say stay-at-home orders have left people feeling trapped indoors. 

But before shopping for quotes or loading up on power tools, homeowners need to have a plan in place to pay for those home improvements and manage any overages due to unforeseen circumstances. The good news is that there are many different ways homeowners can finance their upgrades, from using specific construction loans for home remodeling, to unlocking the power of the equity they already hold in their home. 

Your first question: Is the cost worth it?

Should You Borrow Money For a Home Renovation? 

Home renovations tend not to be cheap, and even a small project can go over budget. 

Some improvements are necessary, while others fall into the category of things that are nice to have but not essential. For example, a new furnace or appliance, or an extra bedroom for in-laws, may be immediately needed — but other projects, while they might improve your quality of life, aren’t an absolute necessity.    

The other key consideration is whether you are in good enough financial shape to borrow money for a home renovation. Especially at a time of economic uncertainty due to the recession caused by the pandemic, ask yourself whether you have a reliable source of income that would enable you to take on new debt. You should also have any other debt — including your mortgage, car loan and student or personal loans, and credit card debt — under control, and at least some savings in an emergency fund

And, crucially, you should know your credit score, the factor that influences more than any other the interest you will pay on the loan for your new project. If a low score would get you an unreasonably high interest rate, focus on building it up before embarking on a potentially costly endeavor.           

Refinancing to Pay for a Home Renovation

For homeowners who have equity in their home, using the value of their homes to finance home renovations can be an effective way to make their living spaces much nicer. 

This is called a “cash-out” refinance, in which you take out a new mortgage for an amount greater than what you owe—and get a check for the difference.

Pulling out equity makes the most sense move your planned renovations will in turn increase the value of your home. Although an upgraded bedroom or kitchen can make a home feel more luxurious, it doesn’t necessarily equate to a dollar-for-dollar improvement. 

“People have in the back of their mind: If I put a dollar in my bathroom, I’ll get two dollars out,” says Christopher Totaro, a real estate agent at Warburg Realty in New York City. “If you really look at the numbers, it doesn’t necessarily work that way. It really depends on the condition of your home,” and how remodeling will ultimately improve the value of your residence.   

Every homeowner needs to start by doing research to determine if improving their homes is the best use of their resources and equity. The experts say you should start by understanding the value of other homes in your neighborhood, and see where your home compares. From there, start looking at the hard numbers: would a planned improvement actually add value to your home? 

The next call shouldn’t be to the bank, but to licensed and bonded contractors in your area. After getting multiple quotes and setting a budget, you can determine if borrowing against your home to perform upgrades is a good idea.  

Make sure your planned improvements will add enough value to offset the cost of refinancing, says Andrina Valdes, chief operating officer of online mortgage lender Cornerstone Home Lending. The closing costs on a new mortgage run between 3% and 6% of the loan amount—an upfront fee that can easily run up to $15,000. 

“Projects with a strong return on investment, like upgrading siding and a deck, are probably going to be worth it,” says Valdes.

Three Home Financing Options

When it comes to home financing options for renovations, there are three primary options homeowners should consider: government-backed loans, conventional cash-out refinancing, or a home equity line of credit. 

Government-Backed Loans

Fannie Mae HomeStyle Renovation Mortgage

  • Homeowners work directly with their contractors to determine the scope of work and budget. Together, they submit their renovation plans with the loan application. 
  • Renovation funds go into a custodial account, from which the contractor can request and withdraw funds. A construction specialist manages the loan, releasing funds as the work is completed. 
  • Homeowners must have at least 10% of their appraised costs in cash, to cover any contingencies that may happen during the construction. 
  • HomeStyle Renovation Mortgages require a minimum credit score of 620, and can be a good option for those trying to control their budget. 

FHA 203(K) Rehab Mortgage

  • Homeowners can perform upgrades on a home at least one year old, and this covers many common renovations: structural upgrades, replacing floors, upgrading to energy conservation improvements and more. 
  • Cost of renovations must be at least $5,000, and payments are managed by a construction specialist who oversees the contractors and their work. 
  • Lenders may charge higher fees for documentation and review, including architectural review and higher appraisal fees. 
  • Because borrowers must meet FHA loan guidelines, this option is great for those who have at least 3.5% for a down payment, a credit score of at least 620, and limited equity in their home. 

Privately-Backed Loans

Cash-Out Refinance

  • Homeowners must have at least 20% or more equity in their home. 
  • Funds are paid directly to the homeowner, and can be used for any purpose, ranging from do-it-yourself upgrades to those from a licensed and bonded contractor. 
  • Lenders may add additional closing costs and fees, including appraisal and origination fees, which may be forced to be paid at closing. 
  • For homeowners who have a clear plan for their renovations, a cash-out refinance can be a great way to add value while taking advantage of historically low interest rates. 

Home Equity Line Of Credit 

Pro Tip

Before starting any renovation project, do your research on other homes in the neighborhood. If building a deck, a fence, or another architectural upgrade helped increase their property value, it could be an indicator of how a renovation could build your wealth.

  • Homeowners must have at least 20% or more equity in their home. 
  • Home equity lines of credit work like a credit card: homeowners are free to spend against the equity of their home as they see fit. 
  • These lines of credit come with a variable interest rate — if the prime rate goes up, you could be paying more to the bank for your project. 
  • High-wealth homeowners who are capable of paying off their home equity line of credit quickly can take advantage of borrowing at low rates, without adding time or money to their first mortgage. 

Alternatives to Loans for Home Renovations

An alternative way to fund home renovations can be a personal loan, if you have good enough credit and can negotiate an attractive APR. A personal loan may be especially attractive to fund a relatively minor expense such as fixing a leak or getting new appliances.

Another option to fund home improvements that do not involve major renovation can be a credit card. While cards typically charge far more interest than personal loans — and you should strive not to carry a balance month to month, so as not to pay that high interest — they may come in handy for smaller jobs.      

Besides standard credit cards, which might give you reward points or airline miles for your expenses, you can choose a co-branded card from home improvement or furniture chains. The Lowe’s Advantage Card, for example, offers discounts on certain purchases made at Lowe’s stores and no interest for six months on purchases of at least $299; the Home Depot Credit Card offers similar terms. IKEA offers a standard Visa card that earns cash back on all purchases, up to 5% for those made at its stores or on its website.

The IKEA Project Card is an example of a card that may be attractive for those who are looking to fund a renovation project without applying for a loan, since it offers 0% APR for up to 24 months depending on the amount purchased. APR jumps to a hefty 21.99% after that, so be sure to pay the balance off before then or you’ll incur interest payments higher than on a personal loan.    

Conclusion

While borrowing against your equity can be an easy way to create the home of your dreams, it can also come with costs and downsides. Before talking to a mortgage officer, look at your overall budget carefully to determine how much you can afford, and how much value it will add to your home overall. 

Refinancing your mortgage to fund renovations doesn’t just have to feel right – it also has to be right for your lifestyle, your finances, and building your wealth. By taking a step back and evaluating all your options, you can determine which route is best for your personal situation.