How to Pay for a Home Renovation
Originally seen on wsj.com
There is usually a better option than just sticking it on your credit card
Home renovations can be exciting, but paying for them requires a lot of planning. If you aren’t careful you could end up with unnecessary debt.
The best way to pay for a home improvement, be it a kitchen refresh or emergency roof repair, is to use cash savings—it costs nothing in interest and leaves you owing no one. But if you have that kind of financial wiggle room, you should consider yourself lucky.
Most of us will have to think about borrowing. Your first thought might be a credit card, since these offer the fastest, easiest route to extra cash. But unless you can pay off the balance in full, there are smarter, and less costly, ways to borrow money for home renovations—for example: a home equity loan, a home equity line of credit, or a rehab loan backed by the federal government.
With the help of personal finance and mortgage experts, we’ll walk you through the options for financing a home renovation.
What to know about paying for home improvements
Home improvement projects come in all shapes and sizes, from fixing the water heater to knocking out walls and expanding your home’s footprint. They’re generally one of two flavors: a-nice-to-have or a need-to-have.
Figure out which category your project falls into before you decide how to pay for it, says Taylor Kovar, founder of Kovar Wealth Management in Lufkin, Texas, because not all projects justify taking on debt.
Need-to-have
Emergencies happen—pipes burst, roofs rot and appliances need replacing. If you have to make a repair to maintain the condition or comfort of your home and you’re short on cash, debt might be your only lifeline. As it happens, the quickest way to get cash will likely cost the most in the long run.
Which is why, ideally, you should aim to budget for need-to-have projects ahead of time, says Jenna Biancavilla, a Phoenix financial planner.“You should be planning for maintenance and repair, especially if you didn’t buy a new build,” Biancavilla says. As a rule of thumb, you can expect those costs to equal about 1% to 4% of your home’s value each year, she says.
For a $500,000 home that means having anywhere from about $5,000 to $20,000 ready to go in a savings or checking account. (Generally speaking, the bigger the house, the more you should budget.)
Nice-to-have
The motivation behind these projects is often cosmetic or luxury. They usually aren’t urgent and therefore may be something to save up for instead of financing.
There are exceptions, though, like if you’re making improvements to increase the value of your home to sell it soon. In these cases, taking on debt may be justified. Just bear in mind the data: While improving curb appeal and upgrading highly-trafficked areas such as kitchens and bathrooms will often boost a home’s value, it’s unlikely you’ll recoup 100% of the money you put into a remodel. (There are some exceptions, of course. According to Remodeling Magazine, replacing your garage door or adding stone veneer siding are two upgrades that offer a measurable return on your investment.)
With a purpose and a timeline for your project in mind, here are several payment options to consider.
Savings
If you have the savings to cover your renovations—even partially, then that’s the route to explore first. Not only will it reduce or even eliminate interest costs, but it could even qualify you for discounts. (Some contractors and suppliers will give you discounts for cash payments, as credit cards come with processing fees.)
Just make sure you don’t drain your savings completely to pay for the upgrades. Financial pros generally recommend that you have at least three to six months of expenses saved up in case of an emergency. If you have a job with unpredictable hours or income, you might want a little more in the bank to be safe.
Home equity loan
Pros:
Fixed monthly payments
Lower interest rate than a credit card
Repayment periods from five to 30 years
Interest payments may be tax deductible
Cons:
Approval to funding can take up to two months
Fixed loan amount
May have prepayment penalties
Need significant home equity
House is collateral
Usually comes with closing costs
How it works & when it’s best: If you own a large portion of your home, a home equity loan is a great, low-cost way to borrow money. You’ll encounter less red tape than you would with some other options like FHA-backed loans, and you may be able to borrow more.
Your home equity is the difference between the home’s appraised value and what you owe on your mortgage. Home equity loans, also called second mortgages, let you borrow a fixed amount of money from that equity pot and use it however you want.
If your home is worth $500,000, for example, and your mortgage balance is $200,000, then your equity is $300,000. The bank will evaluate your credit score and debt obligations, decide how much you can borrow and give you a cash lump sum. (Lenders typically require homeowners to keep at least 15% to 20% equity.)
Repaying a home equity loan is straightforward: Monthly payments are made up of principal and interest—which is tax-deductible if the money is used to “buy, build or substantially improve your home, and they begin almost immediately after you receive the cash.
The fact that the loan is for a fixed amount makes it a smart tool for staying on budget, says Kovar, unlike using credit cards or a home equity line of credit (more on that later).
Home equity loan interest rates are fixed and tend to be slightly higher than primary mortgage rates, yet still far below credit card rates, particularly for borrowers with good to excellent credit. In October 2023, average rates on home equity loans ranged from 8% to 11%, while average credit card rates hovered around 21%.
“If you have the equity in your house, you’re gonna get the best interest rates because your house is being put up as collateral,” Biancavilla says. But that’s also a risk. If you fail to repay what you owe on the loan, your lender can foreclose on the property and take your home. (The same rules apply to your primary mortgage).
Additionally, if your house loses value, you could also end up owing more on your home than it’s worth—sometimes called going “upside-down” on your mortgage. This would mean you could sell your home and not make enough to repay your mortgage balances.
Home equity line of credit
Pros:
Ability to borrow what you need, when you need it
Initial payments are interest-only
Potential for a lower interest rate in the future
Interest payments may be tax deductible
Cons:
Approval to funding can take up to six weeks
Floating interest rates mean payments can go up
Lower initial payments can lead to overborrowing
Need significant home equity
House is collateral
May come with closing costs
How it works and when it’s best: A home equity line of credit, or Heloc, is a way to set up a “revolving” line of credit, which lets you pull money from the equity in your home whenever you need it, up to a certain limit. It’s like a credit card, except it’s backed by the value of your home.
Helocs can be a good method for financing home improvement projects with unpredictable costs, saving you from borrowing too much, or more likely, too little. “Everyone underestimates what they’re going to need,” says Biancavilla. They may also be appealing if interest rates are expected to drop soon, since you don’t lock in a fixed rate with a Heloc (more on that in a moment).
Most Helocs give you access to a line of credit for 10 years, known as the draw period. During that time you only have to make interest payments on what you actually borrow (and, like home equity loans, you may be able to deduct those payments on your taxes as long as you use the funds toward your home).
This interest-only payment scheme means you’re paying a lot less in the beginning than you would with a home equity loan to borrow the same amount of money—but that can sometimes be a “trap,” says Kovar. Eventually, both interest and principal payments will come due. “If you can’t afford to pay that loan back while you’re doing it, then what are you leaning on to be able to pay it back after the fact?” he says.
As Biancavilla puts it, “If someone can only pay the interest, [they’re] gonna end up home broke and that’s not a good long-term financial strategy.” Ideally the homeowner will make an effort to repay what they borrow in full along the way to keep interest costs down and replenish the line of credit, she says.
That’s one other perk of paying the principal during your draw period: If you repay some or all of what you owe, you bring your credit limit back up, and can borrow more as you need it.
One more thing: Like credit cards, Helocs have floating interest rates, where your rate changes based on prevailing market rates, sometimes as often as every month. When your rate moves up or down, so does your payment.
FHA-backed loan
Pros:
Little home equity needed
Down payment can be as low as 3.5%
No minimum credit score requirement (depends on individual lender)
Loan terms range from six months to 20 years
Cons:
Least spending flexibility
Maximum borrowing amount may be lower than non-government-backed loans
How it works and when it’s best: You might think of the Federal Housing Administration as mainly helping first-time home buyers get mortgages. But the government agency also backs home improvement loans for certain types of projects.
With a so-called Title I loan, you can get up to $25,000 to spend on projects that make your home “more livable and useful.” That includes things like adding built-in appliances, widening doorways or remodeling your kitchen for a disabled person, and installing solar panels. If you hire a contractor, you may be able to use the loan to cover labor and materials, but if you do the work yourself, you can only cover the cost of materials.
Pools, outdoor fireplaces and other luxury projects are not eligible for financing with a Title I loan, so if you want full spending flexibility, this loan isn’t for you.
You don’t need to have an FHA mortgage to qualify for a Title I loan, but you need to apply for the loan through an FHA-approved lender and meet their individual lending requirements. You can expect interest rates to be similar to typical rates on FHA mortgages, but the rate you get is determined by the lender.
It’s also worth noting that, due to FHA guidelines, Title I loans between $7,500 and $25,000 are secured by your home. Loans for less than $7,500 don’t require collateral.
Another government-backed option, the FHA 203(k) rehab loan, is for new buyers or homeowners who are refinancing. It lets you combine a home improvement loan of at least $5,000 with a new mortgage or refinanced mortgage. For example, say the purchase price for a home is $300,000 and your down payment is $30,000, your mortgage would ordinarily be $270,000.
With a rehab loan, you can take out more than you need for the mortgage, say $290,000, and use the remaining funds for home repairs. It’s similar to a cash-out refinance, but you don’t need significant equity to qualify. The loans can have either fixed or adjustable rates.
Biancavilla recommends doing your own research on government loan and grant programs before turning to a mortgage loan officer at your local bank. Not all lenders have access to or training for those programs, she says, so they might not present it as an option if you’re looking for home renovation financing.
Personal loan
Pros:
Quicker funding than a home equity loan or Heloc
Fixed interest rates
Straightforward repayment
Loan funds can be used for anything
No collateral required
Significant home equity not required
Cons:
Need strong credit to qualify for lowest interest rates
May have origination fees or closing costs of 1% to 5% of the loan amount
Shorter repayment period than home equity loans, usually between one and five years
Typically higher interest than home equity loans and HELOCs
How it works and when it’s best: As far as its structure, you can think of a personal loan like a home equity loan—you get a fixed amount for a fixed interest rate and start making monthly payments immediately. This can be a good option if you know exactly how much you need to complete a project, or you at least have some cash to cover any shortfall.
The big difference is that personal loans for home improvement projects don’t use your house as collateral. This means they’re quicker to obtain than a home equity loan or a Heloc. But no collateral often translates to a higher interest rate for some borrowers, since it means there’s more risk for the lender, and closing costs. The average rate on personal loans in October 2023 was just over 12%, according to the Federal Reserve.
“That’s where having a really good credit score comes into play,” Kovar says. Without strong credit (or a cosigner), you’ll probably be offered an interest rate that’s closer to what you’d get with a credit card. In that case, it’s better to turn to a home equity loan, provided you have enough equity to qualify.
If a personal loan is your best option, be sure to compare offers from several lenders, not just your go-to bank or credit union, Kovar urges. Online banks, for example, tend to offer comparatively better rates than traditional brick-and-mortars.
Cash-out refinance
Pros:
Single loan may keep financing costs down
Potential for a lower interest rate than a new home equity loan or line of credit
Cash can be used for anything
Cons:
Approval to funding can take up to two months
Closing costs apply to the entire new mortgage amount
Not advantageous if today’s mortgage rates are higher than your current rate
Could mean trading in a lower mortgage rate for a higher one
How it works and when it’s best: A cash-out refinance is yet another way to tap your home equity for cash, but the process is more involved than other options. It requires taking out a new loan that’s larger than your existing mortgage and pocketing the difference.
Say you have a $250,000 mortgage and $200,000 in equity. With a cash-out refinance, you could get a new mortgage for $300,000, shifting $50,000 from your equity into the new loan. That $50,000 would come back to you in cash.
A cash-out refinance leaves you with a single loan, which could lower the cost of financing a home improvement project. That’s because you’re only paying interest on one loan balance, rather than two, such as a primary mortgage and a home equity loan.
But a cash-out refinance is only advantageous if the mortgage rate you can get today is lower than what you’re paying. In the current rate environment, a cash-out refinance would likely mean taking your entire loan balance and setting it at a new, higher interest rate.
For example, if your current loan has a 3.5% interest rate and your refinance today, you’ll transfer that balance—plus the extra you add in for renovations—to a new loan at today’s 7%-plus interest rates, significantly increasing your interest costs in the long run. On top of this, you’ll also pay closing costs, which generally come to anywhere from 2% to 6% of your loan balance.
“That’s going to be way too costly. You don’t need to do that,” Biancavilla says.
Credit cards
Pros:
Quick access to cash
Borrow what you need, when you need it
Possibility of avoiding interest with a balance transfer credit card
Cons:
Higher interest rates than home equity loans
Need very good or excellent credit to qualify for a balance transfer card
How it works and when it’s best: In a pinch, credit cards are an easy way to pay for small home improvement projects—you can instantly borrow the amount you need and spend it on whatever you want. The major downside is that credit cards charge higher interest rates than most other borrowing options, and the rate you pay can fluctuate as often as monthly based on prevailing market rates. It’s easy to get into financial trouble if you don’t pay off your balance in full each month.
Say you charge $1,000 to a credit card with a 20% APR. If you can only afford to pay $50 toward the balance each month, it’ll take two years to pay off the debt and you will have spent more than $1,220 on repayment.
If you have a very good or excellent credit score (around 670 or higher), you may be able to avoid steep interest charges by applying for a balance transfer credit card. This allows you to move your balance from one card to another that has a temporary 0% APR. This grace period can last anywhere from six to 24 months, but afterward your interest rate will jump back up.
Keep in mind, though: There is typically a fee for transferring a balance. The exact amount depends on the card, but you can usually expect to pay anywhere from 2% to 5% of the total balance transferred.
Family loans
Pros:
Potentially lower interest rate than Helocs, credit cards or personal loans
Interest payments may be tax deductible
No formal lender requirements, like a credit check
Fixed repayment term
Cons:
Requires a willing family member with available cash
Loan holder must use federal market rate benchmark to avoid additional tax consequences
How it works and when it’s best: Borrowing money from family may seem like a last resort, if it’s even available to you. But “sometimes utilizing your parents as your loan holders could be a really great idea,” Biancavilla says.
Say your parents are retired and holding onto a significant amount of cash in a high-yield savings account, rather than the stock market, and earning around 3% interest. Meanwhile, you’re considering a Heloc with an 8% interest rate to remodel your bathroom. What about, instead, a loan from the bank of Mom and Dad?
Ideally they charge an interest rate that pays them more than any savings account is yielding, and you get financing that’s cheaper than a traditional bank loan. “That spread between what the parents are getting and what the kids are willing to pay—if you can meet in the middle, both parties would be better off,” Biancavilla says.
The key is treating it like a “real loan,” she adds, to avoid unnecessary income tax consequences. That means the loan holder needs to use the applicable federal rates tables to set the interest rate. The minimum required interest rate on family loans in October 2023 ranged from about 4% to 7%, depending on the repayment term.
The loan holder also needs to abide by a few other IRS rules: setting up a fixed repayment schedule, reporting the interest income on their tax return and putting everything in writing.