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When considering the cost of home renovations, many homeowners today are looking at a cash-out refinance option to tap into their home equity.
Renovations can help your home’s value increase and improve your overall standard of living. But home improvement and remodeling costs can add up quickly.
When exploring refinancing options, one choice that pops up frequently is a cash-out refinance.
This increased interest is because real estate prices have steadily increased for the last several years, which has coincided with rising home equity for homeowners across America.
But is cash-out refinancing a viable choice for home improvements?
To help you out, we’ve put together the pros and cons of cash out refinancing a mortgage to pay for home improvements to see if this is the best strategy for you.
Refinancing a mortgage
When refinancing a mortgage, you pay off the original lender’s loan and switch to a new mortgage, including entirely new loan terms. This change often means a new (hopefully better) mortgage interest rate, new payment terms, and some closing costs.
You could also apply for cash-out refinancing if there’s been enough equity built into your home over the years. This option allows you to borrow more than the original mortgage and get the difference back as cash after closing.
Amounts of equity you can borrow against will vary from lender to lender, but most will allow you to take out a new mortgage that totals a maximum of 80% of the property value.
Example of cash-out refinance
To gain better insight into how a cash-out refinance works, let’s take a look at an example.
You bought a home for $250,000 five years ago with a $10,000 down payment.
Your monthly mortgage payments have decreased your existing mortgage to $200,000. For this example, we will assume that according to an appraisal and the current real estate market in your area, your home’s value is now $305,000,
Most lenders will allow for an 80% loan-to-value (LTV) ratio, meaning you could refinance and get a new mortgage for $244,000.
Whoever holds your existing mortgage would only need a repayment of the $200,000 balance. That leaves you with a cash-out of $44,000, which you can put towards a sizable home renovation project.
Strictly how much cash you have leftover will depend on a few factors.
Cash-out refinancing details will depend on your income, other debts (like credit card debts, student loans, etc.) and your credit score.
Depending on these factors, you could qualify for different loan rates and terms. Don’t forget that there are also some closing costs with a cash-out refinancing.
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Home equity line of credit (HELOC)
Home equity lines of credit (shortened to HELOC) uses your home’s equity as collateral.
As mentioned above, that means the difference between your home’s value and the existing mortgage balance.
On the positive side, most HELOCs generally offer competitive interest rates, especially compared to unsecured debt like credit cards.
On the negative side, a HELOC places a second lien on your home, in addition to the existing mortgage. The more liens you have on your home, the more considerable risk you take.
Cash-out refinance vs home equity line of credit
While the two options may sound similar, a HELOC adds a second payment to your monthly mortgage payment. A cash-out refinance replaces your current mortgage payment.
A home equity loan, which sounds similar, also has a small difference from the two options we mention above. A home equity loan gives the homeowner a lump sum loan that is paid back at a fixed rate.
A HELOC, however, allows the homeowner to borrow what they need, as needed, during the draw period. There’s then a repayment period where it’s paid back with interest. HELOCs also come with an adjustable rate.
Pros and cons of cash-out refinancing for renovations
While it may sound like a straightforward solution for financing renovations or home improvements, is that true for all situations?
Before you move forward on cash-out refinancing, make sure you review some of the potential advantages and disadvantages of this type of renovation refinancing.
Perhaps the most significant benefit of cash-out refinancing for home improvements is that interest rates are typically lower than the higher interest rate of credit cards or a personal loan.
Whenever you contemplate a change in your mortgage, keep an eye on the latest interest rates to see how the financial winds are blowing.
Monthly payments are generally more affordable with cash-out refinancing since the repayment schedule is over a more extended period. For example, personal loan terms can range from only two to five years. You can arrange your new mortgage term to be much longer for cash-out refinances, up to 30 years.
The home’s value
Cash-out refinancing for home improvements can add value to your home when it comes time to sell.
Last but certainly not least, remember you get to enjoy the improvements to your home until the day you decide to sell. An improvement in your quality of life is always welcome.
Like any financial product, there can be a downside to contemplate. So let’s look at some possible negatives that come with the territory.
Depending on how you refinance your home, it’s possible to see an increase in your monthly mortgage payments. Make sure you calculate what they’re going to be by the end of the process, and adjust your budget to compensate.
Some people who opt for cash-out refinancing forget that the longer repayment schedule cuts both ways. Yes, you are spreading out the financial burden over several years. However, you will also have to pay an interest rate on that amount over the same period. That can add up.
The term, part II
Something else to consider is whether it’s a good idea to extend your mortgage. If you have already made ten years of repayments, is it worth delaying the time when you’re paid off your house for another thirty?
Finally, remember the collateral for your mortgage is your home. While a renovation project might add value to your home, the amount is only hypothetical until you sell.
Cash-out refinance for home improvements—conclusion
We’ve covered a lot of ground in regards to cash-out refinancing.
However, it’s reasonable to assume you may have some questions about your situation or refinancing in general.
In this case, a professional mortgage loan officer can be one of the best resources to utilize.
At Homefinity, we’re always glad to answer questions and present refinancing options available to you.
Fill out our short online application, and we can set up an appointment that fits your schedule.