For most homeowners, a new faucet isn't something they need to save for, but a whole new bathroom is likely trickier to pay for. Fortunately, there are several choices for financing home renovations. Here are expert ideas from Dawn R. Cameron, a Home Mortgage Consultant and Renovation Specialist with Wells Fargo Home Mortgage in New York.
How it works: Paying cash for a home renovation is fairly simple -- you save until you have enough to pay for the project as it occurs. Unlike a loan, there's no interest to be paid either.
What you need to know: For small projects -- new sink in a half bath, for example -- a cash-only policy may make sense. Depending on your income, cash as a way to finance home renovations may not take that long to accumulate. For larger projects, it may be more difficult to save enough in a timely manner to pay for the renovation.
2. Loans from other sources such as 401K and IRA funds
How it works: People using this home renovation financing option withdraw cash from sources not intended for use with the home -- a retirement account, for example, Cameron says.
What you need to know: There are tax implications and, typically, penalities incurred. In addition, using 401K or similar funds to finance home renovations also reduces the amount of savings you'll have available at retirement.
3. Home equity line of credit
How it works: A home equity line of credit allows you to borrow against the equity, or ownership, you already have in the home you are currently living in, Cameron says. Most lenders typically allow you to borrow up to 85 percent of what your house is worth. Here's an example: Say your home is worth $200,000 and you have $100,000 on your mortgage. That means you have 50 percent equity in the house, roughly equal to about $100,000. Take that amount of equity and multiply it by 85 percent -- in this case, $85,000 -- and that's probably what a lender will allow you to borrow. You probably have to pay a certain set amount or percentage off every month, but you can keep the line of credit open -- usually for about 10 years -- even after you pay off the total you've borrowed.
What you need to know: The interest rates for home equity lines of credit are variable, Cameron says, so most people don't borrow the full amount on a home equity line of credit. "Home equity lines of credit are connected to the Federal Reserve's prime rate -- usually prime plus some percentage," she says. That means the amount you are charged to borrow the money may go up or down depending on current market situations.
Cameron says home equity lines of credit, sometimes referred to as rainy day funds, are great for giving homeowners access to home renovation financing as they need it. "You're only paying for what you use, and for smaller projects it's perfect," she says. "For bigger renovations, the changing interest rate may be a factor in whether or not you use a home equity line of credit."
4. Cash out refinance
How it works: A cash out refinance provides a homeowner a set amount for renovation that is then rolled into a new mortgage total, Cameron says. Here's an example: Say a house is worth $200,000, and the mortgage is $100,000. The homeowner has 50 percent equity and the home renovation project will cost about $60,000. For a cash out refinance, the original mortgage is paid off and replaced with a new mortgage of $160,000, giving the homeowners $60,000 in cash to do with as they please.
What you need to know: A cash out refinance, which some people also use for debt consolidation, increases the mortgage balance but usually has a set interest rate that's often lower than a home equity line of credit. The interest is also tax deductible.
Home Buying: What to Look for in Your Next Home
5. Renovation financing
How it works: For homeowners that have very little equity, renovation financing may be an option. "It's similar to cash out refinance, but instead of basing the loan on what the house is currently worth, the lender bases it on what the house will be worth when the renovation is complete," Cameron says.
For renovation financing, homeowners refinance their current loan but add on to it an amount needed for the home improvement. The lender then pays the contractor as the work is being done, so the bank is able to ensure the collateral is secure, Cameron says.
What you need to know: Renovation financing helps homeowners improve the value of their home and spread the extra mortgage out over the term of the loan. While the interest is tax deductible, the balance and monthly payment of the home mortgage generally increases. "Homeowners really need to make sure the value is going to be there," Cameron says.
Before you finance a home renovation
Remember: You will typically not get dollar-for-dollar on any renovation project. What you're doing is improving your home and your quality of life. "Make sure your project is going to give you the bang for the buck," Cameron says. Kitchens and baths, for example, are typically good investments.
In addition, research the lender to make sure they are experienced in the type of loan you're thinking about. "The guidelines change so often, so the lender needs to be reputable," Cameron says. You may have to provide a lot of paperwork -- and that's a good thing.