With a few exceptions, using a mortgage to pay for home improvements carries a double-benefit: it increases the value of your home and improves your quality of life. This is common purpose for a cash-out refinance (where you use some of the equity in your home to pay for the home improvements) and there are several ways to accomplish it.
Key point: Determining how much equity you can use
Equity, or the difference between the value of your home and the amount you still own on your mortgage, is a crucial determining factor. Unless you are getting a VA loan, you can’t borrower 100% of the value of your home. You’re normally going to be capped at 80% (for a conventional loan) or 85% (for an FHA loan).
We’ll use 80% in this example: If I have a home value of $200,000, the maximum mortgage I can have (for a cash-out refinance) is $160,000 ($200,000 x 0.80 = $160,000). If I have an existing mortgage of $125,000, then I can access up to $35,000 in equity for home improvements ($160,000 - $125,000 = $35,000).
Easiest Option: You already have enough equity with your current home value
If, in our previous example, $35,000 is enough to accomplish the home improvements you have planned, then the process is fairly straightforward. An appraisal is ordered to determine the value of your home, your income/credit/debts are considered, etc. It’s important to get an idea of how much your home is worth before you get too far into the process. Zillow provides a starting point, but it’s good to get “comps” as well (we provide those!) beforehand to see if you can safely predict how much equity you will have to work with. Remember that an FHA loan will let you borrower 5% more (an extra $10,000 in our previous example), but does carry mortgage insurance (but much of that is offset by the lower rates FHA offers). A VA loan will give a whole lot more, but you have to be careful how often you are using your VA loan benefit (we can help you determine if it’s a wise move).
Other Option: The home value you need depends on the improvements you are considering
Let’s return to the previous example and say you want to upgrade your kitchen and add a room, for a total estimated cost of $50,000. The current appraised value of your home ($200,000) only gives you $35,000 to work with. But, once the repairs are done, your home will likely appraise for $240,000. If you could use the future value of your home as the appraised value, then you would be able to access the full $50,000 needed ([$240,000 x 0.80] - $125,000 = $67,000. There are several ways to accomplish this:
· An FHA 203K Loan: In brief summary, this loan allows you to borrow based on the future appraised value for permitted upgrades. It requires architectural plans, inspections, general contractors, etc. It is an involved process, but if the upgrades are substantial, this is the best way to go.
· A Home Equity Line of Credit (HELOC): This is essentially a 2nd mortgage. If your credit is great and you are solidly qualified, you can often get a HELOC for 90% or more of the current value of your home. In our previous example, that extra 10% would be an extra $20,000, which would give you $55,000 to work with. HELOCs are not the best long-term plan (they are variable and after the interest-only period is over, the payments can sometimes triple or more), but once you’ve completed the work and have the higher value (we estimated $240,000 in our ongoing example), you can then refinance and combine the existing first mortgage and the HELOC into one fixed-rate loan (in this example, a new 1st mortgage of $190,000).
· Self-Financing: This isn’t an option for everyone, but you could essentially pay for the repairs with cash-on-hand or other means. Once the work is done and the home appraises for the higher value (as a result of the repairs), you can then do a cash-out refinance and get your money back.
Tips/Notes
· Consider the scope of the project(s) – If a refinance is not going to get you a lower rate or better terms, or pay off any other debts, then it may not be the best idea to do a full refinance if the project is minimal (I would say under $5000). If the terms of your new mortgage are going to be “worse”, then make sure the size of your project or it’s intended impact are worth it.
· Be careful in estimating your future home value – Putting $30,000 into your kitchen does not necessarily mean your home will then appraise for $30,000 more. There are many factors to consider and it’s best to consult with someone who knows the market/industry before committing yourself.
Evergreen Mortgage has helped a lot of its clients beautify their homes and increase their net worth. If you’re considering some home improvements, give us a call and we’ll go through your options
