Dear Lifehacker,
I have a few remodeling projects I want to get done soon, but I'm not sure how I'm going to pay for it all. Are the "zero percent interest" loans or credit card offers right for this? Or should I apply for a new home loan, like a home equity loan or line of credit? What's the difference between all of these financing options?
Signed,
Financing My Fixer-Upper
Dear FMF,
Home improvement projects—whether you hire a pro or DIY—do cost a pretty penny, so most of us have to take out some sort of loan to pay for them. You've probably received "you've been approved for a personal loan!" letters in the mail or have been told you can refinance your mortgage and take money out for whatever you want. As with other major financial decisions, however, it's really worth the time to understand your different choices so you don't screw yourself in the long run. Let's take a look.
Use Cash If You Can
Cash is usually preferable to accumulating more debt. However, with the average major kitchen remodel costing $54,909 and a bathroom remodel averaging $16,128, it could take decades before you've saved enough to do your projects and actually enjoy the results. For small projects, however, if you're able to save enough in cash, this is probably the best way to go.
You could also do a combination of cash and one of the financing options below to reduce the amount you pay in interest. Also note that by "cash" we mean you pay for the project outright rather than get a loan for it that you pay off slowly. That could mean charging the project to your credit card so you get the rewards for it but then paying your credit card in full when it's due, avoiding the interest.
Pros: No loans hanging over your head, no interest charges or fees
Cons: Hard to save as much as needed by the time you want the project done; no tax benefits as you might get with a home loan
Use 0% or Low Interest Credit Cards for Small Projects
If you have decent credit, you'll run into offers for 0% interest on credit cards (new credit cards or checks you can use with cards you already have). Credit Karma previously advised us that these offers might be best for projects under $15,000—presumably because it's (relatively) easy to pay off the loan within the low interest rate offer timeline (usually 12 to 18 months), it's easy to apply and qualify for, and you don't risk losing your home on this kind of unsecured loan.
Just make sure you understand the fees and terms of these credit card offers and can fully pay off the debt by the time the offer expires—set up an automatic payment to chip away at it—lest you end up owing a ton of interest on the full amount when the offer expires.
Pros: Easy to qualify for, might be able to finance the project without interest
Cons: Lots of pitfalls to beware of, such as offer expiration dates and high interest rates after the offer expires; short payback time period; no tax benefits as you might get with a home loan
Consider Personal or Unsecured Loans for Medium-Sized Projects
For projects between $15,000 and $50,000, Credit Karma says personal or unsecured loans are a good fit. That's because these types of loans are easy to apply for, don't require any collateral (your home is not in jeopardy if you default), and they tend to offer higher loan amounts than credit cards do.
On the flip side, however, interest rates tend to be higher on personal and unsecured loans than they are on home equity or home equity line of credit (HELOC) loans. For example, a $50,000 unsecured personal loan at Wells Fargo has a 7.244% to 9.247% APR, depending on the term of your loan (36 months to 60 months)—which is a great deal more than the 4.06% APR you can get on a home equity loan, according to the latest average posted on Bankrate.
Because terms and rates differ greatly between these niche loan products, it's also harder to understand just what you're signing up for. Steer clear of shady offers, especially payday loans. You should compare the terms, APR (annual percentage rate), and other costs of each loan to see which one makes the most sense. The Mortgage Professor offers many calculators for that tricky task.
Pros: Easy to qualify for, higher loan amounts than credit card offers, usually no closing costs or loan processing fees, longer payback time period (several years versus a year or two for credit cards)
Cons: Higher interest rates than loans secured with your home—so you end up paying more in the long run—and possibly more confusing, sneaky agreements—so you might not understand what you're getting into; no tax benefits as you might get with a home loan
Get a Loan Secured with Your Home for Bigger Projects
If you have equity in your home and are planning on projects costing $50,000 or more, the best loans to tap will probably be tied to your property. HELOCs, home equity loans, and cash out refinances offer the best rates (30-year fixed mortgage rates are among the lowest we've seen in decades, at 4.06% . A 15-year fixed home loan is currently 3.12%, according to WSJ.) Also, you might be able to deduct the interest on these loans and any points you pay to reduce the interest rate on your taxes (check with a tax advisor, though).
That low interest rate has a price, however. There might be hefty closing costs and more application hoops to jump through because these loans, like applying for a mortgage, put your property up for collateral. You'll also need to have enough equity in your home to qualify. For example, if your home is appraised at $200,000 and your mortgage is currently $150,000, you have $50,000 in equity that could be tapped. To reduce risk, lenders usually limit the amount of loans you can have on your home to about 85 percent of your home's value. So in this example, 85% of $200,000 is $170,000; after subtracting the current mortgage amount of $150,000, you're left with $20,000 you could qualify for.
Remember, like standard mortgages, it's all too easy to take more of a loan out on your property than you can handle and end up being underwater on your loan, so you have to make sure you can afford it or else you risk losing your home.
Here are the differences between the home-secured loan types:
Cash-out Refinance
In this scenario, you're replacing your current mortgage with a new one and at the same time taking cash out for your home improvements. This can help you take advantage of today's lower mortgage rates and fund big projects at the same time. Because of the long (30 years, usually) payout plan, you also get lots of time to pay back the loan, and your monthly payments will be lower than if you got a home equity loan or line of credit.
However, a cash-out refinance can be costly in the long run. In addition to possibly high closing costs, you'll pay a higher APR than if you simply refinanced without getting cash out. Also, you'll owe more on your mortgage again, which is not fun at all. If you're 10 years into your 30-year fixed mortgage and refinance into a bigger 30-year loan, the clock restarts. Instead of 20 years left to pay, payments are now stretched over 30 years.
Still, a cash-out makes sense in some scenarios—especially if your current mortgage rate is much higher than what you can get today.
Home Equity Loans (HEL)
Home equity loans are a second mortgage on your home. They're usually a fixed interest rate for the life of the loan, and you get the money in one lump sum. Terms vary, but many home equity loans have you pay back the principle and interest within 15 years with monthly payment plans. This might be the best option if you need a set amount of money for something important and have enough room in your budget to make the payments, of course.
On the downside, however, home equity loans can also be pricey, with transaction fees and closing costs similar to a primary mortgage. There might also be a pre-payment penalty if you pay off the loan early.
Home Equity Line of Credit (HELOC)
With home equity lines of credit, instead of getting all the money you qualify for at once, you have a revolving open credit line, much like a credit card. This makes more sense if you want to borrow money periodically (e.g., projects every couple of years) or just want to have access to more money—but not necessarily take it out all at once.
Again, terms vary, but many HELOCs offer 5 to 10 years for you to access the credit line, during which you pay interest on what you borrow, and then after that draw down period, 15 or so years to pay it back in full.
HELOCs are adjustable rate mortgages, however, so the rate can fluctuate and end up much higher than the rate you'd get on a fixed home equity loan. That makes it much more risky. On the other hand, there are usually no closing costs on HELOCs.
As you can see, the types of financing for home improvements vary quite a bit, and which one would be best for you depends on your situation. Bankrate has a calculator to help you decide between a home equity loan or a home equity line of credit.
Finally, keep in mind that it's probably best to finance only projects that improve your home's value. As our Workshop writer Kit Stansley advises:
I'd also take into consideration which projects will boost property value; those would probably be the best to finance. First of all, if anything is broken— roof needs replaced, HVAC systems need to be upgraded— that would be first on the list. There are also a million articles on
which "upgrades" make the biggest difference in property value
and while I'm not a real estate person I tend to think things like bathroom updates, kitchen updates, and finishing unfinished space like bedrooms and attics would be high up on that list. Building major landscaping structures probably isn't, and I wouldn't recommend financing to, say, put in a pool.
What I absolutely wouldn't do is finance a major upgrade on a house if it puts it outside of the range of comps in an area.
Know where to splurge and where to save on your projects, choose your financing carefully, and enjoy your improved home!
Love,
Lifehacker
Photos by abimages (Shutterstock), ota_photos, rubenerd, Omar Omar, MarkMoz12, pallspera.com.