How to Pay for Home Renovations

You've decided to renovate your home -- but how to finance it?

Banks may be more cautious now that "subprime mortgage" has become a household term, but they are still the primary resource for home renovation financing. You'll probably need very good credit to get your loan approved, however.

Many homeowners finance renovations using the equity they have stored up in their homes. The most common options are a cash-out refinancing and a home equity line of credit (HELOC).

The Cash-Out Refinance

Cash-out refinancing works by adding renovation costs to the principal remaining on your first mortgage.

Say you need a complete kitchen overhaul, at a projected cost of $75,000; your home is worth $500,000, and you still owe $200,000. With a cash-out refinance, you can take out a new, $275,000 mortgage, and use to it pay off the remaining $200,000 on your first mortgage while taking $75,000 in cash for the renovation.

The average interest rate nationwide for a 15-year mortgage stood at 5.72% as of Feb. 28, according to Freddie Mac(FRE Quote) -- leading to monthly payments of $2,270 for a $275,000 loan.

You can find rates for home-equity loans, mortgages and other financial vehicles at BankingMyWay.com.

A cash-out refinance, like any other mortgage, incurs closing costs of about 2% to 3% of the overall loan. You also may choose to pay points -- that is, a percentage of the loan amount -- up front in exchange for a lower interest rate.

The HELOC

A home equity line of credit acts as a second mortgage that you can draw on at will.

Say you need to replace your appliances and tile the kitchen floor, so you take out a $30,000 HELOC that charges 5.76%.

Now say you immediately spend $7,000 on appliances. For the first month, you'll pay interest only on the $7,000 you withdrew, or about $33 a month. The next month, you spend an additional $8,000 on tile -- your monthly interest payments will rise to about $71 a month.

During a HELOC's initial withdrawal period -- anywhere from a few to 10 years -- you must make monthly interest payments, but you can make principal payments as you choose. After this period ends, the line of credit closes and the remaining balance is converted to a home equity loan at market rates.

The interest rates on HELOCs are always adjustable rather than fixed. (Be sure to read your loan documents carefully so that you understand when the rate is scheduled to reset, and how the new rate will be determined.) Closing costs are often $1,000 or less for HELOCs, and the duration of the loan is much more flexible.

Deciding Between the Two

In most cases, a cash-out refinancing is best for large renovations that will be paid off over a relatively long time period. HELOCs, on the other hand, offer a relatively cheap and flexible way to pay off a small to moderate-sized loan over a short period of time.