Refinancing for home improvements: how does it work?

Spring and summer are usually the busiest times of the year for homebuying, but the housing market isn’t the only thing that’s hot right now — so is the market for home renovations.

Many Americans spent a lot more time at home in the past year. This has left them interested in upgrading their homes to either maximize comfort, provide more functionality to their space, or get their homes ready to sell at the highest possible price.

If home renovations are on your wish list and you don’t have enough cash on hand to cover them, you’re not out of luck. There are several options for funding home improvements, including refinancing your home.

Can I refinance for home improvements?

If you have equity in your home, you can turn some of that equity into cash with a cash-out refinance.

In a traditional mortgage refinance, you don’t take any equity out of the home. Instead, you pay off your current mortgage with a new loan — usually to get a lower interest rate or switch from an adjustable-rate to a fixed-rate mortgage.

With a cash-out refinance, you pay off your current home loan with a larger one. The difference between the loan amount of the old mortgage and the new loan (plus closing costs and fees) is generally yours to use as you wish, including paying for home renovations.

How much can I borrow by financing for home improvements?

The amount you can borrow in a cash-out refinance depends on the value of your home and how much equity you have. Typically, homeowners aren’t able to withdraw all their equity.

Most lenders limit the loan-to-value (LTV) to 80%, meaning after your cash-out refinance, you must still have 20% equity remaining.

Here’s an example: Your home is worth $400,000 and your existing mortgage balance is $150,000. You take a new loan for $320,000 (80% of $400,000), and use $150,000 of the proceeds to pay off your original loan. You would take the remaining $170,000 in cash to use for home improvements — or any other purpose.

Lenders may have different maximum CLTVs for second homes, investment properties, and multi-unit housing, so check with your lender for their rules and limitations.

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What are the pros and cons of refinancing for home improvements?

Making changes to your mortgage is a major decision. After all, your home is probably your biggest asset, and your mortgage may be the largest debt you ever take on. Plus, it’s where you live. That’s why you should carefully consider the pros and cons.

Pros

Lower interest rates: Rates on mortgage refinance loans are generally lower than the interest rates available on home equity loans or home equity lines of credit (HELOCs). You may even be able to get a lower rate than you’re paying on your existing mortgage.

Access to cash without depleting savings: A 2021 survey from LightStream found that 66% of homeowners cite savings as their main funding source for home remodeling projects. That’s a smart move if you can afford it, but homeowners should avoid depleting their savings to renovate. It’s important to have a healthy emergency fund in case you need it in a pinch to cover a new roof or an unexpected property tax assessment.

Increase your home’s value: When you use your home equity to pay for home renovations, those renovations may increase the resale value of your home and, in turn, create more equity. Just keep in mind that not all home improvements increase home values.

Possible tax benefits: Mortgage interest can be tax-deductible if you itemize your deductions. Plus, the cash you take from your equity isn’t considered taxable income.

Cons

Potentially higher mortgage payment: When you take out a larger mortgage on your home, you may end up with a larger mortgage payment because you owe more overall. If you refinance into a shorter-term loan — from a 30-year to 15-year, for example — your monthly payment also could increase. But if you have excellent credit that qualifies you for the lowest interest rate available, your monthly mortgage payment could decrease. It’s a good idea to run the numbers to ensure your new payment won’t break your budget.

More interest in the long term: Even if you’re able to lower your monthly payment or keep it the same, refinancing to pay for home improvements will likely cost you more in interest in the long run. That’s because a refinance essentially restarts your mortgage repayment terms.

Lower interest isn’t guaranteed: Generally, you need to have good or excellent credit to qualify for the best home improvement loan deals. If the rate on your current mortgage is already low, there’s no guarantee you’ll be able to get a lower rate by refinancing.

Risk to your home: Remember, when you take equity out of your home, you reduce your interest in the home’s value. If real estate values drop, you could end up owing more on your home than it’s worth. That can make it difficult to sell your home or refinance into a new loan. Plus, if you’re unable to make the monthly payment, you risk losing your home.

Should I refinance for home improvements?

The decision to take a cash-out refinance for home renovations is a personal one. It depends on your overall financial situation, your goals, and how much equity you have in your home.

For example, if you’re considering a cash-out refi to get a lower interest rate and you have upgrades you want to do, cashing out equity can be a smart way to achieve both those goals.

However, if the interest rate on the new loan would be higher than the rate you’re currently paying, you should explore alternatives to refinancing or wait until you have enough money saved to pay for the renovation in cash.

How can I qualify for a home improvement refinance?

While the exact requirements vary from lender to lender, home improvement refinance loans backed by Fannie Mae require:

• A minimum credit score of 640
• A maximum LTV of 80%
• A maximum debt-to-income (DTI) ratio of 45%, meaning all your monthly debt payments, including your new mortgage payment, must be less than 50% of your monthly gross income

Alternatives to refinancing for home improvements

If you’re not confident a cash-out refinance is right for you, consider these alternative home improvement financing options:

• Personal loan: Personal loans usually come with shorter terms than mortgages — five years is the longest term available from most lenders. Also, because the lender doesn’t have the home as collateral, the interest rate is usually higher than you’ll get with a cash-out refi. But funding home improvements with a home improvement loan does not put your home at risk if you’re unable to repay the loan.
• Home equity line of credit: A HELOC allows you to tap the equity in your home, but you only pay interest on the amount of credit you’re currently using. For example, if you take out a $10,000 HELOC but only need to use $5,000 right now, you’ll only pay interest on the $5,000 in use. However, credit lines are usually adjustable-rate loans, so if interest rates go up, your monthly payment and the cost of borrowing go up with it.
• Home equity loan: A home equity loan, which is another type of second mortgage, lets you borrow a lump sum of cash with your home’s equity as collateral and repay the loan in monthly installments. Interest rates on home equity loans are usually fixed, but they’re typically higher than the interest rates available on a cash-out refi or a HELOC.
• Credit card: Credit cards can be a convenient way to finance home improvements. After all, you probably have one in your wallet right now, so you don’t have to go through a lengthy application process. However, the interest rate on a credit card is typically much higher than the rate available from any home equity product, so it can be costly for high-value home projects.