If you’re looking at your chipping laminate countertops, you’re probably wondering what it would take to replace them — and maybe your whole kitchen, for that matter. That leads to the big money question: How are you going to pay for home improvements?
One option is to cash out the equity you have in your home in order to fund improvements on it, by doing a cash-out refinance. A cash-out refinance replaces your current mortgage with a new one and refunds you the difference in cash. You can use the cash however you would like.
However, it’s not your only option, and not every situation is the same. You’ll need to consider what it means to refinance for home improvements and whether or not it’s right for you.
How Cash-Out Refinancing for Home Improvement Works
When you cash out equity for home improvements, you can get a new mortgage and have some equity refunded to you in the form of cash. It’s best to look at how cash-out refinancing works with an example.
Let’s say you own a home worth $800,000 and your current mortgage amount is $500,000. Lenders allow a refinance of around 80% of the home’s value, so 80% of $800,000 is $640,000. $640,000 is the maximum amount that the lender will loan.
Let’s suppose you qualify for that loan. Next, the lender will pay off your original mortgage of $500,000. After you subtract $500,000 from $640,000, you’ll have $140,000 left. You’ll receive $140,000 in cash after you close on the loan (minus the closing costs on the loan). Your new loan amount will be $640,000.
If you want to take a closer look at how much money you would want to have on hand for a renovation, you can use a home improvement cost calculator to form an estimate of potential expenses.
First-time homebuyers can
prequalify for a SoFi mortgage loan,
with as little as 3% down.
What Can You Use the Cash For?
According to Fannie Mae guidelines, which are the regulations mortgage lenders follow for conforming loan types, you can use the cash from a cash-out refinance for anything. That includes whatever home improvement dreams you have — a pool, new kitchen, she-shed, pickleball court — so dream big!
Pros and Cons of a Cash-Out Refinance for Home Improvements
Cash-out refinancing for home improvement has some benefits to consider.
• A better loan. When you apply for a cash-out refinance loan, your loan terms will change with the new mortgage. It’s not guaranteed, but you could end up with a lower interest rate than the one you had on your previous mortgage. Depending on the scenario, it is possible that a refinance could lower the payment for the borrower while accessing cash and shortening the term.
• Increased property value. When you refinance for home improvements, the renovations could increase your property value. New flooring or an updated kitchen could increase the value of your home by more than the amount of money you pour into the project.
• One payment. With a cash-out refinance, there’s one payment for both your mortgage and the cash you take out for home improvement projects. It’s convenient and usually offers a lower monthly payment than other financing methods.
• Lower interest rates than other types of loans. A mortgage has a lower interest rate than other loan types, such as credit cards or personal loans, which can reach an APR of 30%. Just keep in mind that financing over another 15- or 30-year term could add a significant amount of interest to your loan, so be judicious in how much debt you add to your home.
As with any financing option, there are some drawbacks you’ll want to consider before refinancing for home improvement with a cash-out refi.
• Loan terms may change. If you have very favorable loan terms on your original mortgage, you won’t necessarily get those same ones when you refinance. If interest rates have risen since your original closing, the mortgage refinancing cost could make your new mortgage more expensive than an old one.
• What you can borrow depends on equity. You need a substantial amount of equity to be able to do a cash-out refinance. Your lender may only want to lend on 80% of the home’s current market value. That means you’ll need to have an original mortgage amount even further beneath that amount to be able to cash out equity for home improvements.
• Closing costs. With a new mortgage come new closing costs, which are never fun to pay. There are usually fewer closing costs to pay with a refinance, but it’s still a cost you need to consider.
• Long-term costs. Increasing the amount of your mortgage over a long period brings large interest costs. Take a look at an amortization table or mortgage calculator so you know exactly what the total cost of your mortgage will now be.
Requirements for a Cash-Out Refinance
To qualify for a cash-out refinance, you’ll need to qualify for a mortgage again. A lender will look at your credit score, debt-to-income ratio, as well as the amount of equity you have in your home.
Credit Score Minimum
When you’re looking to qualify for a mortgage, you want your credit score as high as possible so you can qualify for the best available mortgage rates. For the best rates, aim for a credit score of 740 or above. A credit score of 620 is needed for most home loan types, though you may be able to get a home with a credit score around 500, depending on the type of mortgage or program available in your area.
Home Equity Requirements
The amount of your new mortgage will retain around 20% equity before refunding cash (sometimes less, depending on the lender or the program). If your home is worth $500,000, that means they’ll likely be willing to lend up to $400,000 on the home. If your current mortgage sits at $300,000, the most cash you would be able to access with a cash-out refinance is $100,000.
Debt-to-Income Ratio (DTI)
A debt-to-income (DTI) ratio is the total sum of your debts divided by your income. Generally, lenders look for a DTI ratio at 43% or lower. There are exceptions, so be sure to consult with your lender.
Cash-Out Refinance vs Home Equity Line of Credit (HELOC)
Another way to pay for home improvements is with a home equity line of credit (more commonly referred to as a HELOC). A HELOC is a second mortgage loan that uses the equity in your home as collateral. It acts like a line of credit and you only borrow what you need. It’s flexible and easy to use.
It makes sense to use a HELOC instead of a cash-out refinance in a few scenarios:
• When the interest rate on your current mortgage is very low. Changing your current mortgage to a higher-interest mortgage with a cash-out refinance would be very expensive. Paradoxically, a HELOC or personal loan will have an even higher interest rate than what you can get on a primary mortgage, but because you’re paying the HELOC or personal loan off sooner, you will spend far less in interest.
• You can make a larger HELOC payment. A HELOC usually won’t take 30 years to pay off. On a HELOC that is paid off sooner, the monthly payment amount will be higher, but if the numbers make sense (meaning, you’re able to access enough money for your home improvements from a HELOC at a competitive interest rate and you can cover the payments), then you probably want to go with a HELOC instead of a cash-out refinance.
• You’re not sure how much you need. With a HELOC, you apply for a credit line and are approved up to a limit, kind of like a credit card. You only take out what you need, which is convenient when you’re planning a project and are not sure exactly how much it will cost.
Cashing out the equity for home improvements can be an affordable way to update, repair, or improve your home — but only if the circumstances are right. While a lump sum of cash can be a great way to pay for home improvements, be sure to factor in all the costs before you choose this method. There are other financing tools available to you if this one is too costly.
Turn your home equity into cash with a cash-out refi. Pay down high-interest debt, or increase your home’s value with a remodel. Get your rate in a matter of minutes, without affecting your credit score.*
Can I use a cash-out refinance for ongoing or future home improvement projects?
The cash you get from refinancing your home can be used for any purpose.
How long does the process typically take for a cash-out refinance for home improvements?
The cash-out refinance process averages 30 to 45 days regardless of what purpose the excess funds will be used for.
Can I use a cash-out refinance to fund home improvements on an investment property?
Yes, however the requirements for a cash-out refinance on an investment property may be different from those on your personal residence, so it’s best to consult with a mortgage lender.
Are there any restrictions on how I can use the funds from a cash-out refinance for home improvements?
No, there are no restrictions on how to use funds from a cash-out refinance. You can pay for whatever home improvements you would like. There are restrictions, however, on whether or not you can deduct the interest you pay on the loan on your taxes. Ask your tax preparer for guidance.
Can I apply for a cash-out refinance for home improvements if I have a second mortgage or existing liens on my property?
Yes, but the second mortgage and other liens will likely need to be paid for a lender to issue a new mortgage for a cash-out refinance. There are some exceptions, so it’s best to consult with your mortgage professional on this one.
Photo credit: iStock/Kerkez
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