Low interest mortgage rates have given some homeowners the option to refinance their mortgage and free up extra cash, either through lower monthly mortgage payments or a “cash out” refinance in which they borrow against the equity in their home.
Homeowners can use this money in a variety of ways, including paying off debt or paying for their children’s college expenses. But is it a good idea to use this extra cash for home repairs or renovations?
We asked Kathryn Hauer, a financial counselor in Aiken, South Carolina, and Roslyn Lash, a financial counselor in Winston-Salem, North Carolina, for their views. Hauer and Lash are members of NerdWallet’s Ask an Advisor network.
What are the advantages of refinancing to pay for home renovations?
Roslyn Lash: One of the main advantages of refinancing is to receive a lower mortgage rate that reduces the overall cost of the loan, which ultimately results in a savings. Refinancing could easily allow a person to “cash out” with enough funds for home repairs without an increase in the mortgage payment.
For example, if you received a 30-year, $200,000 mortgage at 6% five years ago, your monthly payment is $1,200, excluding taxes and insurance, and your current balance is $186,109. If your home repairs are estimated at $10,000, a cash-out refinance may be the best option to renovate the property without straining the family’s budget.
You would take out $10,000 in the refinance, giving you a new mortgage of $196,109 at an interest rate of 3.5% for a 25-year loan. That would result in a payment of $982. You’d pay off your home as originally scheduled and save $218 a month.
What are the potential disadvantages?
Kathryn Hauer: If you get cash back in addition to your refinance, you could end up with a higher monthly mortgage payment, depending on how much you take out. You don’t want to reduce your savings rate — for example, contribute less to your 401(k) — as a result of a refinance.
Roslyn Lash: Once you add the fees into the loan amount, the total cost of refinancing could outweigh the actual benefits. You must carefully analyze the numbers to determine if refinancing is the best option. To get a realistic estimate of the total cost, it’s imperative to get a loan estimate from each potential lender. This estimate will not only provide total cost, but getting one from a couple of lenders will provide a true comparison of fees.
Is refinancing a better option than a home equity line of credit?
Kathryn Hauer: Refinancing can be a better option than a HELOC if you plan to stay in your home for more than five years and if you can refinance to an interest rate lower than your current rate. If you think you might move soon or if your current mortgage rate is already low, a HELOC would probably be a better choice.
Roslyn Lash: Determining the best option between refinancing or a HELOC depends on your individual financial situation. If you have a mortgage of 3.8%, for example, it’s unlikely that refinancing would benefit you, since your rate is already low. In this case, your best option would be a HELOC, if the monthly payments are affordable. Each individual must take into account the current interest rate, remaining term and mortgage balance, as well as income and other debts. A careful analysis of these figures will determine the most affordable and feasible option.
If the costs of a planned home repair or renovation are minimal, and the monthly payment is within the household budget, it may be more economical to get a HELOC because some of the traditional fees may not apply. Of course, the disadvantage to getting a HELOC is the obligation of a second, although smaller, mortgage.
What are some tips to best take advantage of the refinancing option?
Roslyn Lash: Look closely at the interest rate as well as the fees. It’s not uncommon for a lender’s interest rate to be low, but for the fees to be excessive. This strategy lets consumers think they’re getting a good deal when in actuality the cost of the “one-time” fees eats away at their overall savings. Compare each lender’s annual percentage rate. The APR provides an accurate comparison because it combines the refinance rate and the fees.
Kathryn Hauer: Shop around for the best refinance rates and don’t forget to evaluate the deals at your local credit union. Also, make sure you reduce outstanding credit as much as possible and pay your bills on time in preparation for the application process so you get the best rate possible.
What else should consumers should know before they decide?
Roslyn Lash: Refinancing could let you get rid of private mortgage insurance premiums. When the mortgage was initially taken out, if the homebuyer didn’t contribute at least a 20% down payment, PMI was included in the payment, resulting in a higher mortgage payment. However, as the mortgage balance decreased and property values increased, it’s possible that the PMI could be eliminated, thus further reducing the payment.
Kathryn Hauer: Be honest with yourself. Are these home repairs that you want — replace an ugly but functional patio — or that you need — repair a leaking roof? Sometimes you have repairs that are necessary and unavoidable, so if you plan to stay in your home for a few more years, a refinance could be the perfect solution. However, you don’t want to refinance only to put in a swimming pool that the children quickly outgrow, while you scrape up cash to cover your higher payments plus the kids’ college tuition.