How to Refinance for Home Improvement

When people talk about refinancing for home improvement, they’re typically talking about using a cash-out refinance loan to fund home renovation projects. With a cash-out refinance, you borrow more than you owe on your current mortgage, and the excess amount is converted into cash.

Whether you want to remodel your kitchen or bathroom, add in some solar panels or simply replace your roof, using a cash-out refinance can be an excellent way to boost your home’s value and potentially take advantage of lower interest rates.

How to Use a Cash-out Refinance for Home Improvement

With a cash-out refinance, the more equity you have in your home, the more cash will be available to you. You can use these steps to determine if you have enough equity in your home to cover your renovation needs.

Step 1: Assess Your Home Equity

Using a cash-out refinance means tapping into your home equity, which is the difference between your home's current market value and the amount you still owe on your mortgage.

For example, say your home is worth $300,000, and you still owe $200,000 on your mortgage. Your equity would be $100,000 ($300,000 - $200,000).

To determine your home equity, you’ll need an accurate estimate of your home’s value, which has likely changed since you took out your current mortgage. This is why cash-out refinancing requires a home appraisal. In the meantime, you can use an online home valuation tool to get an initial estimate to help you plan.

Step 2: Calculate Cash-Out Amount

Conventional lenders typically allow you to borrow up to 80-85% of your home's value. With a home worth $300,000, you’d qualify for a cash-out refinance loan of up to $240,000 (80% x $300,000) to $255,000 (85% x $300,000).

For our example, let’s say you opt for a $240,000 cash-out refinance loan. A large portion of this amount goes toward paying off your original $200,000 mortgage balance. This would leave you with $40,000 in cash to use for home improvements ($240,000 - $200,000).

However, some lenders have less stringent LTV requirements. At Veterans United, we allow VA Cash-Out Refinance borrowers to refinance up to 90% of their LTV. In our example, this would add up to $70,000 in cash.

Step 3: Determine Renovation Costs

Next, assess the cost of the renovations you want to undertake. You’ll want to account for material costs, labor and permits. You should also budget a cushion for any unexpected costs.

To get an idea of material costs, you can look at prices on home hardware store websites, consult with a contractor or use online searches. For labor, you’ll get the most accurate estimate by getting direct quotes from contractors in your area.

Once you’ve calculated a forgiving renovation budget, compare your expected expenses to the funds you will receive from your cash-out refinance. You want to ensure you have enough home equity to meet lender requirements and enough cash to cover renovation costs.

You’ll also want to account for closing costs. Most lenders will allow you to roll them into the loan amount, but it will be subtracted from the cash-out portion if they don't.

How to Qualify for a Cash-Out Refinance

Refinancing replaces your current mortgage with a new one, meaning you have to meet standards similar to those of a purchase loan – even if you’re applying for a refinance with the same lender as your current mortgage.

Specific qualifications will vary by lender, but they are likely to be within these ranges:

• Loan-to-Value Ratio: Lenders will typically have a cap on how much you can borrow with a cash-out refinance. For conventional mortgages, it’s often 80% of the home’s value. VA loans generally allow homeowners to refinance up to 90% of the value.

• Credit score: Conventional lenders typically require credit scores that qualify as “good” or “excellent.” According to FICO, a “good” credit score is 670 or higher. However, some other loan types may have lower minimum requirements. For example, a common benchmark for a VA Cash-Out Refinance is 620.

• Debt-to-income ratio (DTI): Your DTI ratio is important because it shows lenders the percentage of your gross monthly income that goes toward paying debts. DTI ratio limits can vary by lender.

Pros and Cons of Using a Cash-Out Refinance to Remodel

Before you commit, you’ll also want to weigh the pros and cons of a cash-out refinance:

Pros:

• Lower interest rates: Mortgage rates are often lower than personal loans, credit cards, and home equity loans. Depending on the market, you may be able to get a lower rate than your current mortgage, meaning lower monthly payments.
  
• You can increase your home’s value: Investing in home improvements can increase your home’s value, making it a sound financial decision in the long run. Just make sure your home improvements are strategically planned.

• Interest is typically tax-deductible: If your renovations improve the value of your home, the interest on your cash-out refinance may be tax-deductible. Consult with a tax professional to ensure your home improvements qualify.

Cons:

• You have to pay closing costs: Like any mortgage loan, a cash-out refinance typically involves closing costs, such as appraisal fees, origination fees and title insurance.
  
• You’ll have more to pay off: A cash-out refinance increases your mortgage balance, which means you'll owe more on your home loan. This can extend the time it takes to pay off your mortgage and increase the total interest paid over the life of the loan.
  
• You lose home equity: By tapping into your home's equity for cash-out refinancing, you're immediately reducing the amount of equity you have in your home. Even if your renovations increase your home’s value in the long run, you’ll lose equity in the short term. This could be risky if property values decline, leaving you with little or even negative home equity – which is when your loan amount exceeds your home’s market value.

Alternatives to Refinancing for Renovation

If a cash-out refinance doesn’t sound like the right option for you, rest assured that there are many other loan options available for home improvement.

Here are 5 common alternatives to refinancing for renovation:

1. Energy-Efficient Loans: Energy-efficient mortgages (EEM) allow borrowers to finance energy-efficient upgrades when purchasing. They aren’t as common for refinancing, but it depends on your lender. At Veterans United, energy-efficient mortgages can also be used in conjunction with other loan products like the VA Streamline Refinance.
   
   
2. Renovation Loans: The VA Rehab Loan, FHA 203(k) Loan and Fannie Mae HomeStyle Loan are three types of renovation loans meant to finance both a home purchase or refinance with repair costs added on. They may be a good option for buyers or homeowners who don’t have significant cash reserves or home equity built up.
   
   
3. Personal Loan: Personal loans can be used for various purposes, including home renovations. They typically have fixed interest rates and repayment terms, making them predictable and easy to budget for. Personal loans may be a good option for smaller renovation projects or for homeowners who don't have significant equity in their homes.
   
   
4. Home Equity Loan: A home equity loan allows you to borrow a lump sum using your home's equity as collateral. It is a secondary mortgage loan, meaning it won’t replace your primary mortgage. The loan is typically repaid over a fixed term with a fixed interest rate.
   
   
5. Home Equity Line of Credit (HELOC): A HELOC is a revolving line of credit that allows you to borrow against the equity in your home as needed. It is a second mortgage (like a home equity loan) and typically has an adjustable mortgage rate. You can draw funds from the line of credit during a specified draw period, usually up to 10 years, and repay the borrowed amount plus interest during the repayment period. HELOCs offer flexibility, allowing you to borrow only what you need for your renovation project.