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The combination of widespread lockdowns, cabin fever, and super-low interest rates over the past year has made refinancing for a remodel a great option for many homeowners.
The summer of 2020 saw a 60% increase in remodeling inquiries on the popular site Houzz.com compared to 2019. For those interested in financing part or all of a remodel, a cash-out refinance is a solid option thanks to rates that — while higher than they were earlier this year — are still historically low.
A cash-out refi makes sense if you can get a lower interest rate on a new mortgage. But the refinance will increase the principal you owe, so only take what you need.
Refinancing for Home Improvements: How it Works
Homeowners commonly use refinancing to snag a lower interest rate or to shorten the mortgage term (or do both, ideally). Both of these tactics, and especially when combined, can help to reduce the interest you pay over the loan’s life.
For some homeowners refinancing is a way to free up money by turning home equity into cash during the refinance process. This is called a cash-out refinance or cash-out refi.
A cash-out refi means taking a new loan to replace your original mortgage. If you take a new loan that’s larger than what you owe on the home, then you can pocket the remaining cash.
“If you have a $500,000 home and you owe $250,000 on it, you could do a cash-out refinance where you take $50,000 of equity out and turn that mortgage into a $300,000 mortgage. You now owe $300,000 on your $500,000 home, and the bank who gave you the mortgage pays you the difference,” says Arthur Knouse, Realtor at Keller Williams in Santa Fe, New Mexico.
Consider the Cost of Refinancing
While many homeowners can reap big savings on interest via a refinance, it’s important to note the process isn’t free.
“The thing to be aware of is the lender fees, title fees, and some other costs that come along. So you want to make sure that the amount of money you’re taking out makes sense with the associated costs,” says Knouse.
A new, more expensive mortgage is a big commitment, and some may feel wary of the idea of restructuring their current loan. While the cash-in-hand you’ll receive is important to consider, another prime concern is the new mortgage.
“One rule of thumb I have is that people should think twice about a refinance unless there’s a minimum of a point difference in the interest rate. If someone has a 4 percent interest rate, you should be able to get a 3 percent rate or lower,” says Curt Davis, founder of RealEstateWealthCoaching.com, a real estate investing firm.
The closing fees that come with refinancing are often substantial — 3 to 6 percent of the total loan amount. But that’s not necessarily a dealbreaker for cash-strapped homeowners who are looking for ways to refinance a badly needed home improvement project.
“If you have enough equity, sometimes you can roll the cost of refinancing into the new loan. So, in theory, you could do it with no money out of pocket. But it will add more to the loan,” says Davis.
Pros and Cons to Cash-Out Refinancing For Home Improvements
The purpose of your home improvement is the first thing to consider when looking into a cash-out refi. People decide to undergo home improvements for different reasons, says Dr. Jessica Lautz, VP of demographics and behavioral insights at the National Association of Realtors.
“One is to improve the home that they’re living in, such as upgrading worn-out furnishings or materials to improve liability and functionality within the home. The second is if there are also items within a home that a potential seller needs to fix up before putting the home on the market,” says Dr. Lautz.
Having a clear goal in mind is central to deciding if a cash-out refinance is right for you. Every bit of equity that you turn into cash must be paid back. Although it can be a helpful resource for home improvements, restructuring a mortgage can also work against you.
- Mortgage and refinance interest rates are still on the low end right now. If you signed on to your original mortgage when interest rates were higher, then you could get a cash-out refi with lower interest.
- If the cash is for home improvements, it should increase your home equity. It’s helpful to research improvements that carry the widest appeal, so you can recoup the cost of your investment. This is especially true if you plan to sell.
“A kitchen upgrade or a full kitchen remodel actually only recoup about 50%,” says Dr. Lautz.
On the other hand: “New wood flooring recoups 106 percent. A hardwood flooring refinish recoups 100 percent. People really like those new floors. They look beautiful in photos. They look beautiful once you enter the home, and they are also something the homeowner can really enjoy, as well,” continues Dr. Lautz.
- The fees you pay when refinancing a mortgage are based on the entire loan, not just cash you’ll get back. So expect to pay thousands of dollars during the process. If the improvements you want are not expensive, then a cash-out refi might not be the right option, and you can find less expensive ways of financing the improvements.
- Another concern is if you plan to sell soon. A cash-out refi means you’ll be taking a mortgage that is more than what you currently owe. You’ll also have to account for the fees. If you want to put the home on the market soon, make sure you have enough time to recoup these new expenses.
Refinancing Vs. HELOC Vs. Home Equity Loan For Home Improvements
A cash-out refi for home improvements works well when interest rates are low, and a substantial amount is needed for the improvements. If interest rates were high, you might want to keep your current mortgage and explore other options.
When you use a cash-out refinance, you get all of the money as a lump sum. If you don’t know exactly how much you’ll need for the improvements, then you might take too little or too much. If any of these issues describe your situation, other financing options exist for home improvements.
Home Equity Loan
Also known as a second mortgage, a home equity loan allows you to take a new loan against your home while keeping the first mortgage as is. This option is good for homeowners who want a large sum of money at one time but don’t want to alter the original mortgage. Keep in mind the interest rate here may be less favorable.
“With a second mortgage, the terms can vary, but the rate is typically higher than a first mortgage because your second mortgage is in second position. In the event of a foreclosure, the primary mortgage gets paid off first. If there wasn’t enough money to pay off both mortgages, the second mortgage might not be paid off. So that’s why you have the higher rate,” says Knouse.
“People will basically use it as a credit card to pay off bills and things like that. It’s a lot more flexible than a second mortgage, where you don’t have as many options,” says Knouse.
A HELOC allows you to only take the money you need, so this option could be good for homeowners with ongoing home improvement projects. This option also means you won’t have to change the current terms of your mortgage.
How to Choose the Best Option
If you’re looking to finance a home improvement right now, current interest rates make cash-out refinancing the most attractive option.
Not only can you pull equity out to pay for home improvement, but you may also lower your current interest rate at the same time. “Using the cash from a refinance to increase the value of your home is one of the best uses of that money,” says Davis.
Refinance mortgage rates are better than HELOC or home equity loan rates. “It’s probably the best interest rate you’re going to find. Especially right now, where interest rates are low historically. I think that’s the biggest plus side — you can borrow much more cheaply than through other means,” says Knouse.