Should you use cash, a mortgage refinancing, line of credit or second mortgage to fund that remodeling project? Here are some tips and a Q&A.
Summer is coming, and homeowners may be contemplating remodeling projects and household repairs during the warmer months. But with interest rates starting to rise, consumers should carefully consider their financing options.
The recovery in housing prices means that more people have equity in their homes that they can tap for projects like adding a bathroom or updating a kitchen. As interest rates tick upward, though, homeowners may want to consider whether to draw on that equity for a remodel.
“I do think the rate landscape is a factor at this point in time,” said Greg McBride, chief financial analyst at Bankrate.com.
So if you’re planning a home upgrade, how will you pay for it?
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If you have the cash, it’s wise to consider using it, because interest rates paid on savings are still quite low, said Robert Schmansky, founder of Clear Financial Advisors, outside Detroit. If you must finance the work, then a home-equity loan or line of credit “isn’t the end of the world,” he said, although he suggested paying it down as quickly as possible.
With interest rates trending up, refinancing an existing mortgage to take out cash for a remodeling is becoming less attractive. The average rate on a 30-year, fixed-rate mortgage was 4.03 percent last week, according to Freddie Mac, up from 3.66 percent a year ago.
Home-equity lines of credit, which function like a credit card rather than a traditional term loan, have been one of the most popular ways to finance remodeling. Lines of credit, or HELOCs, however, are more complex to manage than a traditional second mortgage and come with variable interest rates, typically tied to the prime rate. That means monthly payments will rise — perhaps more than some homeowners are comfortable with — if the interest rate on the loans increases.
Lines of credit typically have a 10-year “draw” period, during which borrowers use the available funds as necessary and make interest-only payments. After the draw period, the lines usually convert to regular installment loans, with monthly payments of both interest and principal required over another 10 to 20 years.
The average rate on a home-equity line of credit is 5.45 percent, McBride said, although some lenders offer initial “teaser” rates as low as 2.99 percent for an introductory period, typically six months.
Before the financial crisis, as home values skyrocketed, borrowers used the lines to finance all sorts of things, from vacations to new cars. But since the recession, borrowers have been using the lines more responsibly, to fund specific upgrades on their homes or to pay for college costs, said Mike Kinane, general manager for home equity products with TD Bank.
“The majority of it is remodeling,” he said.
The average draw — the amount of the credit line that is in use — is about $50,000 nationally, Kinane said.
Home-equity loans — a traditional second mortgage, typically made at a fixed-interest rate — may be more palatable than lines of credit as rates rise.
Kinane said he had seen a “very slight uptick” in applications for home equity loans, rather than lines of credit, as borrowers react to news of rising interest rates.
But home-equity loans may be harder to find, McBride said. Many larger banks stopped making them, preferring to offer lines of credit, which reduce risk to the lender from rising rates. Borrowers who do locate home-equity loans, however, are likely to find rates that are comparable to the average rate on a line of credit. “You have to shop around,” he said.
The choice is ultimately dependent on the consumer’s risk tolerance. “If they don’t like the possibility that the rate can change,” Kinane said, “then the loan product is probably a safer bet.”
There is one more way to manage the risk of rising rates: Many lenders offer the option of converting the amount of money that you have already drawn from a line of credit into a fixed-rate loan to lock in a rate.
Here are some questions and answers about home-equity financing:
Q: Do I have to use a home-equity line of credit right away?
A: Some lenders require a “minimum draw” when you close on the line of credit, McBride said. So make sure you know about such requirements and consider whether it meets the timing of your project. If you must borrow $10,000 right off the bat, but your contractor can’t schedule you for another several months, you’ll end up paying interest unnecessarily.
Q: Is there any disadvantage to using a fixed-rate home-equity loan for a remodel?
A: Loans are made in a lump sum. You can’t borrow more if your project goes over budget. Revolving lines of credit are more flexible. You borrow as you need the money. So they may make more sense for projects that are being done in stages over a longer period of time, McBride said.
Q: Can I deduct the interest I pay on a home-equity loan or line of credit?
A: Generally, yes. But check with your tax adviser.