My wife and I have lived in our home for 14 years. It's gone up in value significantly. Currently the home is worth $850,000. We refinanced about 6 years ago and have a 3.375% rate with a balance of just under $300,000. We would like to do some major work (Kitchen, add a bathroom, new landscaping) and have received bids for the projects so we can estimate the cost at about $100,000. What is the best way to pay for this?
There a number of ways to pay for home improvements. Because you have substantial equity in your home, it makes sense to compare the different options for using the equity to pay for your home improvement projects. Interest rates on home loans are likely to be much lower than what you will be offered for an unsecured personal loan and the monthly payment will be smaller, too, as you can finance the home loans for a longer period of time.
To qualify for a home loan, lenders will look at three main areas:
Equity- Lenders limit the amount you can borrow from your home. In 2019, most lenders will not go above 80% of your home's value for any loan in which you take cash out. You have a lot of equity in your home. Even after adding in the $100,00 you estimate for your home improvements, you will still have borrowed less than 50% of your home's value.
Credit- . Home improvement loans don't require that you have excellent credit. Borrowers credit scores above 620 can qualify, though each lender sets its own minimum credit score requirement. Your excellent credit will get you the best rates available, but it is important to shop around to compare the rates and fees from different lenders.
Income- With strong equity and excellent credit, lenders will be eager to work with you, provided you have enough income to meet their debt-to-income (DTI) requirements. You can check your DTI here.
There are three options you want to compare for using your home equity to pay for your home improvments:
A Home Equity Loan (HEL) is a second mortgage. With a HEL, you choose a fixed amount that you want to borrow, close on the loan, and receive a check for the amount you have chosen. HELs usually carry a fixed interest rate, though there are adjustable rate HELs available. A fixed-rate HEL has a required monthly principal and interest payment that never changes, though you can pay it off sooner if you wish. If you stick to the required payment, the loan is paid off in full at the end of the loan term. If you know exactly how much money you need, a HEL is a solid option. If you decide later that you would like to draw additional funds, you will need to arrange for an additional loan with additional closing costs.
A HELOC, is a Home Equity Line of Credit. The lender approves you for a HELOC of a certain size and you can use any or all of that amount as you see fit. You only pay interest on the portion of the line of credit you use.
HELOCs are often structured with a draw period and a repayment period. During the draw period you have access to the entire amount of the credit line you were given. Some HELOCs require a monthly payment during the draw period that is interest only. Pay attention to this! If you are paying only interest, your payment is going to rise substantially once the repayment period starts and you are paying principal and interest. The draw period is usually 10 years.
HELOCs have adjustable interest rates, so you could see an increase in your required payment during the draw or repayment period, if interest rates rise.
During the repayment period you are no longer able to take additonal funds out. Repayment periods usually begin after 10 years, whether you have a HELOC that is for a 20-year or 30-year term. There is no penalty for paying off a HELOC early.
Another way to pay for your home improvements using your equity is to refiance your current mortgage. Your new loan will pay off the current mortgage and give you the money to use on your remodeling projects.
How your current loan's interest rate compares to the rate you are offered today is the key factor in deciding if a cash-out refinance is a good choice. In your case, you refinanced your loan at a time when rates were at or near historic lows. Today, in 2019, rates are low, but not as low as what you are paying. It makes no sense to increase the costs on your current near $300,000 mortgage balance. However, if refinancing your current loan would lower your rate, there is a strong incentive to skip a second mortgage and apply for a cash-out refinance.
You have already gone out and received bids for the projects you wish to undertake. That is a smart step to take for determining how much you need to borrow, but the bids are not carved in stone. Many remodeling projects run over budget and you are taking on multiple projects.
A strong benefiit of a HELOC is flexibility. You can apply for a HELOC that is larger than your needs, buidling in a cushion in case your home improvement project runs over budget, and only pay interest on the money you use. You can pay it down and then draw on it again, during the draw period.
WIth a HEL, you pay interest on the full amount you borrowed, staritng with your first payment. If you need more money, you have to apply for a separate loan.
You want to weigh in the interest rates for the two options. HELOCs will likely start wtih a lower interest rate than a HEL, but the HELOC is an adjustable rate loan. Be aware of the maximum rate your HELOC can reach and be sure you can afford the payment if rates reach the max allowed.
Be cautious, however, about the amount that your borrow in an equity loan. If you ever default on a home equity loan, you put your house at risk.
Shop around to compare rates and fees, but also to listen to the advice of the different loan officers with whom you speak. Each person's situation is different and someone may point out something about your goals and overall financial picture that causes you to change how you view things.