Home Insight - Property Value and Home Price Check
What's the Smartest Way to Pay for Your Home Improvements?
Written by: Lankarge/Nahorney for HomeInsight

Looking to tap your home equity to fund a remodeling project? You're not alone. U.S. residents have more than $500 billion in home equity debt according to the FDIC. During the second quarter of 2005 alone, 74% of mortgage refinancing activity was for more than the original mortgage balance as homeowners took cash out of their homes in record numbers.

Pay Cash or Get a Loan?
Homeowners with cash may find it tempting to pay outright for their home improvements. While it may be cheaper in the short run to finance your project with cash, if you're the type of person who would not be averse to putting that cash to work in a stock mutual fund, you might want to reconsider. That's because, over time, compounding can make that $20,000 investment double or even triple, a sum many times more than the interest you will pay on the loan.

Remember, home mortgage interest is tax deductible and interest on the first $100,000 of a home equity loan or line is usually also tax deductible. What does this mean? Well you pay about one-third of your income in state and federal income taxes. So, for example, if you are considering a loan with a 6 percent interest rate, in effect you are only paying about 4 percent after taxes. Another reason to borrow the money and invest your cash is that, since 1929, the stock market has returned an average of 10 percent per year. This is much higher than the 6 percent interest you will pay on the loan.

Let's say you decide it is finally time for the orange countertops and black kitchen cabinets to go. A $20,000 loan at 6 percent would cost you $6,645 in interest over 10 years. However, after taxes, that amount would be closer to just $4,430.

But if you invest that $10,000 at 10% per year, that same $20,000 becomes $54,141 in 10 years.
If you're planning a home improvement, you may believe that planning the project, selecting the contractor, and keeping him on time and on budget are the most difficult aspects of remodeling. However, while each of those tasks can be challenging, it is equally important to decide how to finance your project.

The first step is to determine the scope of your project. Exactly what work needs to be done? If you're planning to remodel your kitchen, go down to the local home improvement store to see what materials are available. Another good idea is to go to a local home show where you can see a wide variety of products up close. You can also speak with contractors to get an idea of how much your project might cost. From your notes, you can develop a rough budget.

Once you have your rough budget, you should examine your financing options. Basically, there are four ways to finance your remodeling project:

  • Cash. If you have enough money in savings, the least expensive way to finance your project in the short run is with cash. However, as you see from the accompanying sidebar, you might want to think twice about paying cash.

  • Home Equity Loan. Formerly called a second mortgage, home equity loans commonly carry fixed interest rates over 5-, 10- or 15-year terms.

  • Home Equity Line of Credit. These loans differ from home equity loans in that they commonly carry a variable interest rate tied to the prime rate. Most often your pay interest only on the loan amount. At the end of the term, you will owe the principal.

  • Mortgage refinance with cash out. With the value of homes soaring in the past 10 years, homeowners are pulling out some of that equity and sprucing up. Mortgages often carry interest rates lower than either home equity loans or home equity lines of credit and are most commonly for 15- or 30-year terms (although some 40-year mortgages are available).

    Compare current loan rates now.

    After reviewing the current rates, you might be asking "how large of a loan will I qualify for?" In the past, you could only tap 75 to 80 percent of the equity in your home. However, products on the market today allow loans of 100 to 125 percent of the value of your home..

    Which Loan is Best for You?

    Mortgages often carry lower interest rates than home equity loans. But if you spread out those payments over 30 years, you will pay more in interest than you would if you selected a home equity loan or line and chose a shorter loan term. While many homeowners who have chosen adjustable rate mortgages were pleased with that decision when interest rates were dropping, as the Fed raises the prime rate, adjustable rate mortgages are becoming less popular. Fixed rate mortgages are getting a larger market share as these rates remain historically low. Refinancing a mortgage with no points will cost you about $2,500.

    Home equity loans offer fixed rates for 5-, 10- or 15-year terms. While rates for home equity loans are often higher than mortgages, because they're usually for a shorter term the total cost of the loan including interest is less. Most home equity loans do not carry any origination fees.

    Home equity lines are growing in popularity and size. The average home equity line of credit climbed to nearly $78,000 in 2004, up from about $57,000 in 2001, according to Benchmark Consulting International in Atlanta. Home Equity Lines offer homeowner flexibility. They are essentially a revolving line of credit with a maximum spending limit. To access the money, you write a check or use a special credit card, then pay back interest only on the money that is borrowed. Some homeowners use the home equity lines for emergency cash. They also don't carry origination fees.

    To determine which route is best for you, determine how much equity you can pull out of your home, and then compare the different interest rates available to you.

    If you do decide on a large home remodeling project, please refer to the article Bubble Trouble for a look at protecting your investment in a hot housing market.