Many dream of being able to remodel their kitchen or build an addition onto their home, but are kept from pursuing the dream further because of the costs involved. A relatively simple remodeling project can end up costing tens (or even hundreds) of thousands of dollars, which is outside the means of many homeowners. When money is tight, some even have trouble coming up with the cash for basic do it yourself projects.
At the same time, not being able to write a check upfront for your home improvement plans does not necessarily mean it is beyond your means. There are a number of ways to finance a home improvement project. If you want to update your ugly old 1970′s era kitchen, for example, consider your monthly discretionary income. If you can afford the payments and are comfortable with the cost of financing, then financing your home improvement project may be good to consider – and there are number of ways to go about it.
Credit Cards are a common way to finance things for which people cannot afford to pay cash. Credit cards have a set credit limit, and cardholders pay with the card for any purchases under that amount. Since most people have credit cards, it is a simple way to get money for smaller home improvement projects.
For larger projects, credit cards are not ideal. Credit limits are typically under 50 thousand dollars, and home improvement projects can cost more than that. It may be harder to be approved for a card than a loan that uses the house as collateral, especially for a larger credit limit. Interest rates for credit cards can be double what borrowers would pay for another type of loan, and late payment fees can be up to 30% of the payment. Credit card borrowers may end up carrying a balance on their card for longer than planned, which in turn lowers their credit score.
Personal loans are another option for borrowers not looking to borrow much. These are loans directly from a lender to the borrower, based on the borrower’s credit score. There is more flexibility towards what the money can be used for, and there is no risk to the borrower’s home if they cannot pay the loan back. Borrowers who have good relationships with their banks can secure loans with interest rates comparable to home equity loans, and lower than credit cards.
Unfortunately, lenders do not give out as many personal loans, so the credit criteria can be quite high. Loan amounts are often lower than a credit card limit would be, so expensive projects could not be financed this way.
A second mortgage is a mortgage taken out on a home while the homeowner still owes money on the original mortgage. These can be varying amounts, depending on how much equity is available. The interest rates can be lower than credit cards or personal loans, and they are easier to qualify for since the loan is against the house.
Since a second mortgage is against the home, defaulting on it puts the home at risk of foreclosure. The interest rate is higher than a regular mortgage, and there are many fees involved with a second mortgage; this may make it impractical for someone with other options available to them.
Home Equity Line of Credit (HELOC)
A home equity line of credit could be thought of as a combination of a second mortgage and a credit card. Borrowers are given a credit limit up to the amount of equity in their home, and they can use as much as they need. This is ideal for projects that start out small and keep getting more expensive, because the borrower is already approved for the maximum amount, but only has to pay interest on the amount used. The interest paid is tax deductible for federal income tax, and the funds are available until the line of credit is closed, so even after it is paid off the money is there for the borrower in the future.
Like a second mortgage, this loan is against the house rather than the borrower. If it is not paid, the borrower will lose their home. Unlike a mortgage loan, if the house is foreclosed upon, the borrower may still be liable for the amount owed; as a result, the lender can pursue them for the balance. If the value of a house drops significantly, a lender may consider that a foreclosure risk and freeze the line of credit.
Another option is cash-out refinancing, which allows homeowners to remortgage a house for a larger amount than they owe (up to the value of the house), taking out the equity in cash. Often refinancing will give homeowners a lower interest rate, which will lower their payments. Often the payments for refinancing will be lower than a home equity loan.
Refinancing does require another closing, however, and closing fees can be high. It is a less than ideal solution for people who have almost paid off their loans, whose payments are more principle than interest. Homeowners who borrow more than 80% of their home’s value may have to pay private mortgage insurance, which will raise their monthly payment.
Whether a homeowner chooses to use a credit card to pay for a project or completely refinance their house is an individual decision, but knowing all the options available is the first step to choosing the option that fits their needs.