While paying for simple repairs and small improvements can be covered by a household budget, larger projects like replacing a roof or updating a kitchen typically require financing. Different home improvement loans are best for various kinds of projects. Here are the top four strategies for financing home improvements.
FHA: Home Equity Loans with No Home Equity
FHA offers a loan program for purchase and renovation or refinance and renovation under its 203(k) loan program. This program provides funds based on the as-improved appraised value of the home. The maximum loan amount for an FHA 203(k) loan is limited to the lesser of:
- The FHA loan limit for the property location
- The appraised value of the home plus renovation costs
- 110 percent of the home's as-repaired appraised value
The 203(k) refinance loan pays off the existing mortgage and also funds the renovation. Money for renovations is placed in an escrow account and paid out as the work progresses. The FHA 203(k) loan program also requires borrowers to pay for FHA mortgage insurance of 1.75 percent upfront and an annual mortgage insurance premium.
Cash-out Refinance: Run the Numbers
Homeowners with good credit may qualify for conventional cash-out refinancing. Cash-out refinancing replaces the current mortgage with a new, larger home loan, and the borrower gets the difference in cash at closing. Homeowners who want to refinance their mortgage and get cash out, however, should compare the cash-out refinance to a "regular" rate and term refinance plus home equity loan before committing. That's because closing costs are significantly higher for cash-out refinances, and the fees are based on the entire loan amount, not just the cash out.
Home equity loans and HELOCs cost much less to set up, but their interest rates are higher than those of first mortgages. In general, the larger the project, the more likely it is that a cash-out refinance will be the less-expensive option. Smaller projects are usually more cheaply funded with home equity loans or HELOCs.
Home Equity Loans
A home equity loan, also called a second mortgage, is secured by the home but is taken in addition to the first mortgage, not instead of the first mortgage like a cash-out or 203(k) refinance.
It typically comes with a fixed interest rate, a fixed monthly payment and it is repaid over a (typically) five to 20 year term. This loan provides homeowners with a lump sum of cash. It's most useful in cases where project costs are known and not expected to vary much, and the entire amount is needed at once. It's a good idea to borrow a little extra as a cushion to cover unexpected expenses. Home equity loans work well for meeting one-time finite expenses. Examples of one-time projects include installing new floor coverings or windows that have been contracted at a specific price.
A HELOC can be a great choice for major home renovations that are completed over a longer time period and funded in increments. HELOCs provide homeowners with a revolving credit line that can be used as needed. This allows homeowners to pay as work is approved, and can save finance charges as interest is charged only on amounts actually withdrawn.
A HELOC also offers flexibility because cash is immediately available up to the credit limit. HELOCs typically have adjustable interest rates and monthly payments are calculated from the account balance and the interest rate.
Homeowners should keep in mind that these home improvement loans are mortgages that can be foreclosed for non-payment. The rate paid for home improvement financing has a direct effect on the renovation's return on investment, which makes it important to compare home equity rates and choose financing with the best terms.