How to use cash-out refinance for home improvement

How to Use Cash-Out Refinance for Home Improvement

July 4, 2022

A brief overview

One way to find the funds for your home improvement projects is to use a cash-out refinance loan. This works by tapping into your current home equity so that you can get a lump sum that to use for any home improvement projects. Here’s how to use cash-out refinance for home improvement.

Key Points

For real estate investors doing fix and flip projects, or homeowners who would like to renovate their house, the first thing to figure out is financing. There are a few options to choose from, but one of the common methods is by using a cash-out refinance loan. These types of loans can easily be used for home improvements and will suit a fix and flip project well. They will save you having to take out expensive personal loans, overextend your credit card or get a second mortgage. We’ll go through the ins and outs of how to use cash-out refinance for home improvement, so that you can make a more informed decision for your next fix and flip project.

Home interior

What is a cash-out refinance loan?

The money you have paid into an existing mortgage becomes equity on the home. You can use this equity to finance other projects like home renovations or improvements. A cash-out refinance loan essentially replaces an existing mortgage with a new one that is larger. This helps homeowners to use the existing equity in their home to finance another loan and access the difference between the two loans as cash. Usually the terms on a cash-out refinance loan are more favorable.

How does a cash-out refinance work?

A cash-out refinance is quite similar to buying a home in terms of the process. However, the equity you have built up in your current home is the amount that you can take out as cash. In other words, you’ll refinance your mortgage for more than you owe, and the difference is paid out to you as a lump sum. However, bear in mind that you’ll only be able to take out about 80% of this, the rest will need to be left in the mortgage so that there is still some equity.

For example, if you have a home worth $300,000 and your current mortgage is $100,000, your home equity is $200,000. According to the general 80% rule for refinancing, you’ll have about $60,000 left in your mortgage once you’ve refinanced, and you’ll be able to borrow $140,000 for your project.

It’s worth noting that you are liable for the closing costs on a refinance, so this may come out of your total amount. You also may have higher interest rates because it is a larger mortgage. Also, you might need to have your home appraised, which will be another cost that would come out of your lump sum.

Refinance quote

How to use cash-out refinance for home improvement

1. Meet the requirements

Once you have decided that you’d like to do a cash-out refinance, you’ll need to meet the requirements. Each lender has their own criteria for acceptance, so do your homework on the lender that you have chosen. Some common requirements that many lenders will want are; a credit score of 620 or higher, a Debt-To-Income (DTI) ratio of less than 50% and a large amount of equity in your home.

2. Choose the amount

Decide on how much money you’ll need for your home improvement projects by working out what needs to be done, and how much each job will cost. You can consult with general contractors in your area to help you work this out. This will dictate the loan amount that you’re applying for.

3. Submit an application

Then it’s time to apply with the lender that you’ve chosen by filling out their application documents and supplying all the relevant additional documents that they may need, such as bank statements, pay stubs and so on. Once you’ve been approved for the loan, your lender will provide you with the rest of the steps. Then you’ll be paid out after a few working days and you can begin your home improvement projects.

Pros of refinancing for home improvement

  • Lower cost: A cash-out refinance offers you a more affordable way to finance your home improvements than other kind of loans. Due to the fact that it’s a mortgage, interest rates will likely be lower than say a personal loan.
  • Lump sum payment: You’ll receive all the money in one go, which means that you won’t need to spread it out over a longer period of time and pay more interest on it. It’s also useful for home improvements to be able to pay for everything when it’s needed.
  • Possibility of lower interest rates: If you apply for a cash-out refinance when interest rates are low, you could end up with a mortgage with even lower interest rates than you had before. Which means that you’ve borrowed more money, but you’re paying less interest, win-win!
  • Increase home value: Home improvements are adding to your home’s value, which works out well because you’re spending less on interest rates, while adding more to your home’s value.
  • Single payment: A cash-out refinance means that you can continue with just one mortgage payment every month that may not be much higher, instead of multiple payments.
  • Tax deductions: Depending on the area, you may qualify for a tax deduction on the interest on your mortgage.

Cons of refinancing for home improvement

  • Longer repayment period: A cash-out refinance means that you’ll be consolidating your debt into one place, however this can lead to a much longer loan period where you’ll be repaying the debt for a longer time.
  • Your home is collateral: Once you’ve taken a cash-out refinance, your home is used as collateral. If you cannot make the payments, your home can be put into foreclosure.
  • Higher monthly repayment: Now that you’ve added onto your debt, you’re likely to be paying more each month on your repayment, which is an adjustment, and you’ll need to make sure that you have budgeted for this.
  • Closing costs: A cash-out refinance involves closing costs and you’ll be liable for these. Refinancing costs are usually between 2% and 5% of the loan. These costs will come out of the total amount that you’ll be paid out. So, if you’re planning on only taking out a small amount, a refinance may not be the best idea.
  • Private mortgage insurance: If you borrow more than 80% of your home’s value, you might need to take out private mortgage insurance (PMI) which is an extra cost that adds up to 0.55% to 2.25% of your loan amount every year.
  • Slower process: A cash-out refinance isn’t going to give you quick access to funds because the underwriting process can take a few weeks.

Other ways to fund home improvements

home improvements

Home Renovation Loan

A home renovation loan is a loan used to fund home improvements and it’s based on the After-Repair Value (ARV) of the house. Which means that the value of the home, once the project is complete, is used to determine how much you can borrow. Lenders typically determine the rates on these loans from the Loan-To-Value (LTV) ratio.

The FHA 203(k) Loan is one of the most used home renovation loans. This loan is particularly useful for real estate investors or homeowners who would like to purchase a property and then upgrade it. The loan covers both the purchase of the home and the renovations. FHA loans are backed by the federal government and only require a down payment of 3.5%. Applicants will need a minimum FICO score of 620 for an FHA 203(k) loan.

Hard Money Loan

Hard money loans are another way that investors or homeowners can source funding for their home improvement projects. These are particularly useful if you need money fast because hard money loans can be closed within days. They also offer a smoother and easier application process, because they don’t stick to the same stringent lending criteria that traditional financial institutions do.

Hard money loans provide fast finance, in a lump sum, and while the interest rates are higher, it’s a good solution for home improvements that need payment all at once, or improvements that need to get started right away.

Home equity loan or HELOC

Home equity loans and home equity lines of credit (HELOC) both allow you to dip into the current equity you have on your home. With a home equity loan, you can take out a lump sum, and with a HELOC you can borrow as you need funds because it’s a direct line of credit. These options are second mortgages, so you’d have two monthly repayments, however they have minimal closing costs.

Both of these loans can have higher rates than a cash-out refinance due to the fact that it’s a new loan. They also use your property as collateral, so if you cannot make your repayments, your home can be put into foreclosure. One big advantage that these loans have however, is lower interest rates and terms than personal loans or credit cards, for example.

Final thoughts

A cash-out refinance loan is one of many options to finance your home improvements. The benefits can be great, however, to make sure that it’s the right fit for you, consider how much equity you’ve built up in your home, how much money you need, whether you meet the requirements, and whether your cash flow can sustain the increase in monthly repayments.

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