Maybe you’ve lived in your home for some time and you’d like to upgrade some elements. Or maybe you recently moved in and want to make some changes to enhance the space. Either way, you might be wondering how you can afford these expenses.
A cash-out refinance may be the answer. Refinancing can be an affordable way to get tax-free cash for remodeling your kitchen, finishing your basement, or another project.
Consider this a primer on how cash-out refinancing works, and what you need to know about using cash from your home for repairs and renovations.
What Type of Loan is Best for Home Improvements?
In this scenario, you refinance your mortgage for more than you owe and take the difference in cash. The more equity you have the more cash you can extract. And perhaps the best part is that you can do this without any tax penalties. You’ll have to pay it back as part of your mortgage balance, but it’s at a much lower interest rate than other means.
Another benefit is that you may use the cash for home improvements or anything else you need. Think debt consolidation, tuition, or even a newer car. It’s up to your discretion.
How Do Home Improvement Loans Work?
To qualify for this loan, you and your home must first meet certain requirements. For instance, your credit score will need to be at least 620, but that number can vary according to a number of factors like your loan type, how many units the property has, and how much cash you’re taking out.
There’s also the equity variable, as mentioned above. When you apply to refinance, your lender will require an appraisal of the property to assess property value. If you’re unsure how to determine equity, it’s fairly simple. Subtract your current loan balance from the appraised property value and you have the amount.
It’s important to realize that the minimum amount of equity you’ll need to leave in your home when you refinance varies by loan type and by lender. With a conventional loan, you’ll typically need to leave at least 15 – 20% equity in your home.
If you refinance with an FHA loan, the terms usually specify you need 15% equity in your home. VA loans, on the other hand, are more generous in that you can refinance 100% of the home’s value. In other words, you don’t have to leave any equity in the home if you meet the credit score requirements.
Debt-To-Income Ratio (DTI) Requirements
Your debt-to-income ratio (DTI) is another important piece of the puzzle. This calculation is determined by combining all your recurring monthly debt and dividing it by your gross monthly income. The maximum DTI allowed varies by loan type and lender, but you’ll typically need a DTI of 50% or lower.
The Perks Of A Cash-Out Refinance
In addition to an influx of cash to help fund your dream project or projects, getting a cash-out refinance can come with other benefits, too. For instance, you can benefit from:
Low-Cost Home Improvements
A cash-out refinance can make home improvements more in reach when you don’t have the funds to allocate. Refinancing can be a good way to borrow a considerable sum at once, which means large-scale renovations can be less of a financial burden.
Boost Your Property Value
Certain improvements can add value to your home. If you lock in a lower interest rate you’ll come out ahead if your house is worth more when you go to put it on the market. The right features could make your home more appealing to buyers, too.
Maintain One Payment
A cash-out refinance isn’t the only way to fund home renovations, but it’s likely to be the most manageable. Home equity loans, personal loans, and credit card debt add extra payments and more interest, which can be daunting.
By choosing a cash-out refinance vs. a home equity loan or other loan product, you’ll only have to manage one mortgage payment that may not be much higher than the one you have now.
Low Interest Rates
Credit cards or personal loans can be used as methods of payment to fund home renovations, but they don’t come without a cost. (Interest rates can be in the double-digit range.) When you refinance your mortgage, you can borrow money at a much lower interest rate and can rest easier knowing the projects won’t set you back financially.
You May Get A Tax Deduction
Mortgage interest is usually tax-deductible, but the interest on many other types of debt is not. Depending on your location and the tax code in your state, the interest you pay on your mortgage can be deducted. Check with a tax professional for more information to determine if you qualify.
Other Considerations
In addition to the perks mentioned above, there are key points to keep in mind:
The Amount You Borrow Depends On Your Equity
Lenders typically require you to maintain 15 – 20% equity in your home after a cash-out refinance. This can mean the scope and scale of your home improvements can be stifled. If you had a costly project in mind, or if your appraisal comes back lower than you thought it would, you might have to find other ways to pay for the work.
You’ll Get Different Loan Terms
As with any refinance, a cash-out refinance changes the terms of your loan. You’ll get a new loan with an adjusted interest rate, and your payment will change to reflect the new sum.
This could mean a larger payment, but that’s not always the case. For example, if you’re resetting your term to 30 years, or if you’re getting a lower interest rate, your payment won’t necessarily go up.
Refinancing Requires Closing Costs
A cash-out refinance is like any other refinance, which means you need to plan for closing costs. The closing costs will typically be subtracted from the cash you’re getting, so you won’t have to pay anything out of pocket.
The Bottom Line
It’s best to lay out all of your financing options to find the best path forward for your home renovations. While a cash-out refinance comes with some risk, you may be comfortable with it if you have a strong financial safety net in place to stay on top of your mortgage payments over time.