How to Use a Cash-Out Refinance for Home Improvements

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If the value of your home is greater than what you owe on your mortgage, you might be eligible for what is known as a cash-out refinance. A cash-out refinance is a loan that replaces your current mortgage with a new, larger loan. The difference between the old loan and the new one (minus fees and costs) will be yours to spend. It’s a way to potentially turn a portion of your home’s equity into cash you can use now.Of course, there are pros and cons to applying for a cash-out refinance. There are also good and bad reasons to tap into your home equity. Using a cash-out refi for home improvements that could add value to your home is arguably a good reason, depending upon your specific situation.

Advantages of cash-out refi for home improvements

Let’s start with a look at some of the advantages to using a cash-out refi to pay for home improvements.

  • A cash-out refinance might lower your mortgage interest rate.Perhaps the biggest potential advantage of the cash-out refi is the fact that you might be able qualify for a lower interest rate on your new loan. This is especially true if interest rates have gone down since you took out your current mortgage. If your credit rating has improved since you took out your current mortgage, your odds of securing a lower interest rate may be higher as well.You should also consider the potential downside.You should weigh the fact that not every refinance automatically results in a lower interest rate — there’s a chance you might pay more for your new loan — and even if your rate is lower, your new loan will likely extend the number of years you carry a mortgage.

    Tendayi Kapfidze, chief economist with LendingTree, which owns MagnifyMoney, recommends that homeowners exercise caution before deciding to refinance. “With a cash-out refi, you might end up with a higher rate than your previous loan due to rates trending upward. That could be somewhat disadvantageous.”

  • A cash-out refinance can help you roll debt into a single loan.If you’ve decided to borrow money to pay for expensive home repairs or home improvements, a cash-out refinance offers you the opportunity to simplify your debt. Instead of taking out a separate loan or paying for those costs on a credit card, you can roll all of your debt into a single loan.
  • A cash-out refinance may offer more freedom in how you can use borrowed funds.When you take advantage of a cash-out refinance loan, the extra money you borrow is often yours to use as you see fit. If you want to use $30,000 to update your kitchen and apply the remaining $5,000 toward paying off your credit card debt, that’s your prerogative.By comparison, using other types of loan products to finance home improvements may involve a bit more red tape from your lender. Some loans may require to you use the funds strictly on an approved home improvement project.
  • A cash-out refinance may be tax-deductible.
    New tax reform laws passed in 2018 put more restrictions on mortgage interest tax deductions. However, the good news is that if you use your cash-out refinance to substantially improve your primary home, the IRS might still allow you to take a deduction on the extra interest fee you incur from your increased mortgage. Naturally, as with any tax-related questions, it’s best to consult a certified tax expert with your questions.

Of course, you shouldn’t consider the advantages of a cash-out refi without weighing the disadvantages as well.

Kapfidze made an important point that homeowners should remember: “Keep in mind, you’re reducing the equity in the home when you take out a cash-out refi. Your house is collateral as well. Make sure you can meet that monthly payment or you might be putting your house at risk.”

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Cash-out refi vs home improvement loan with no equity

Despite numerous advantages, a cash-out refinance isn’t the perfect fit for everyone and every situation. Even if you’re basically sold on the idea of a cash-out refi, it’s smart to compare alternative financing options before you make a final decision.

LendingTree’s Kapfidze pointed out one reason why a cash-out refinance might not work for some borrowers — lack of equity. “You need to have equity in the house in order to take cash out.”

If your home doesn’t have enough equity built up for you to access, you may need to find a different way to finance your home improvement project. A home improvement loan with no equity is a common alternative.

Here are a few facts about home improvement loans with no equity that may help you make a more informed decision.

  • These types of loans come in several different varieties, including
    • Unsecured personal loans
    • 401(k) loans
    • Government-insured renovation loans (e.g., Title 1 loans, FHA 203(k) loans, etc.)
  • Home improvement loans with no equity may have stricter limitations on the maximum amount you can borrow. If the money you need to finance your home renovations exceeds the maximum amount you can borrow, this type of loan might not meet your needs.
  • When you use something other than a cash-out refi loan, lenders may place more restrictions on how you are allowed to spend the money you borrow. With government-insured loans like the Title 1 loan, for example, you can’t use the funds to pay for anything considered a “luxury item,” such as a swimming pool or outdoor fireplace.
  • If you use a personal loan to finance your home improvement project, it might cost you. Personal loans often feature higher interest rates than cash-out refinance loans. Higher loan costs, if applicable, should always be factored into your decision.
  • Using a 401(k) loan to finance home repairs or upgrades can be a cost-effective choice like the cash-out refi. However, the risk is also high because you’re borrowing from your own personal retirement savings. Plus, you might also be subject to tax penalties if you fail to pay the loan back according to the terms of your agreement.

Home repairs and maintenance

When you think “home improvement loan,” replacing a busted hot-water heater might not be the first thing that comes to mind. However, unexpected home repairs and maintenance can be costly as well.

Many homeowners do not have sufficient emergency funds tucked away to pay for big-ticket repairs. Even smaller maintenance tasks can become pricey when several pile up at once. If you find yourself in either of these situations, a cash-out refinance might be worth contemplating.

Here are just a few examples of common home repairs and maintenance costs where funds from a cash-out refi could solve a big problem:

  • HVAC replacement
  • Roof replacement or repair
  • New windows
  • Well or septic repair
  • New hot-water heater
  • Gutter maintenance
  • Paint or siding maintenance
  • Chimney cleaning or repair

Before you decide to borrow, remember that your homeowners insurance policy might cover certain damage repairs as well. It’s a good idea to check with your insurance provider to see if you can file a claim to cover some or all of the damage before you begin researching financing choices or tapping into your savings.

Renovations

Using a loan, cash-out refinance or otherwise, to renovate your home can be a smart decision if the project adds value to your home. If you spend $25,000 but gain $35,000 in equity, the extra money borrowed is probably a good investment.

However, not every home improvement project is a great idea. Before you pull the trigger on an expensive upgrade, it’s wise to do some research first. Just because you enjoy a home upgrade personally doesn’t mean that it will add value to you home.

According to a remodeling impact study by the National Association of Realtors, here are the top six renovations likely to add value to your home:

  • Complete kitchen renovation
  • Kitchen upgrade
  • Bathroom renovation
  • New roofing
  • New vinyl windows
  • New garage door

Remember, the best way to finance home improvements and repairs is typically with cash. As a homeowner, it’s important to save for inevitable maintenance and improvement costs. Yet when you’re not prepared to pay in cash, the benefits of improving your home now versus waiting can sometimes make taking out a loan a wise decision.

Every loan comes with benefits and risks. If you plan to borrow for a home improvement project, take time to list out the pros and cons associated with each loan product you are considering. Doing so will make it easier to weigh the choices against each other and choose the option that is truly best for your specific situation.

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Michelle Black
Michelle Black |

Michelle Black is a writer at MagnifyMoney. You can email Michelle here

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