For most people, the first options that come to mind for paying for a home renovation or repair are to save and pay cash or to borrow money from a bank. While either could be best for your particular financial situation, there are many alternatives to pay for your project that could potentially be better for you.
Cash / Savings
Paying for home renovations or repairs with cash is pretty straight forward. You either save or transfer the funds into your account from another source and pay for any related expenses. Even as many other transactions have shifted to being digital, cash is still a popular form of payment for home improvement contractors.
Advantages
- Less risky than borrowing funds
- Some contractors may offer a discount for paying with cash
- Don’t need to spend time researching and applying for other types of funding
- No additional fees
- No monthly payments
- No paperwork to get setup
- No need for credit checks, to show prove income or assets
Disadvantages
- Can be more advantageous to allocate money towards investment, retirement or elsewhere
- If payments deplete savings too much, an additional unexpected expense could be difficult to pay for
- No tax deductions
- Removes some leverage from home value appreciation
Credit Cards
Credit cards are very useful when cash isn’t on hand or for people who are looking to earn extra rewards on their purchases. A credit card can offer a short term buffer before having to use cash or savings to pay for home improvements, but if you end up paying interest, any rewards are typically eradicated by the very high interest rates. There are some cards that offer 0% intro APR rates that you can leverage to only make minimum payments for almost 2 years before incurring any additional charges. As long as you can pay off the balance after the introductory period is over, this can be a way of getting an almost free loan. Depending on how extensive your home renovation or repair ends up being, the costs could end up being higher than your available credit. Another issue is that not all contractors accept credit cards as a form of payment so you may need to utilize another funding method.
Advantages
- Can be less risky than taking out a loan
- Less paperwork to get setup
- May offer intro incentives and/or rewards
- Offers a short term payment buffer
Disadvantages
- Requires credit check
- High interest rates if not paid in full
- May need to still utilize other funding methods
- No tax deductions
- Removes some leverage from home value appreciation
Home Equity Line of Credit
A home equity line of credit (HELOC) is a common way for many people to pay for home improvement projects or home repairs. Many people, even those high incomes, may not have the cash on hand to pay for a major home project.
Simply stated, a home equity line of credit is similar to a credit card. You apply with a lender to borrow a maximum amount of cash and they approve you with terms for any amount that is borrowed. You aren’t required to spend the entire amount that you are approved for which provides flexibility that can be very useful in most home renovations. Once approved, you are given a draw period, which is a fixed amount of time you are allowed to borrow money. Typically, the draw period is 5-10 years. Once this draw period is over, you can either apply for a renewal to extend it or you will be required to fulfill the payment obligations. This could mean that you are required to pay the balance in full or pay over a period of time called a repayment period. The repayment period is commonly 10-20 years. To qualify, a lender will review the amount of equity you have in your home and may allow you to borrow up to 80-85% of this amount.
Similar to a mortgage, a HELOC can have a number of fees, besides interest, when using this type of lending:
- Application fees
- Upfront charges, like points
- Credit report fees
- Appraisal fees
- Attorney fees
- Title search fees
- Mortgage preparation and filing
- Transaction fees
- Annual fee
In 2018, the Tax Cuts and Jobs Act went into affect which had an impact on how and when interest on HELOCs could be deducted from taxes. After the changes, a home equity line of credit was only tax deductible if the funds are used specifically for home improvement projects and the total of any related home loan (mortgage, HELOC, etc.) do not exceed $750,000 for married taxpayers or $375,000 for single filers. If the home was contracted to be purchased before December 15, 2017 and closed before April 1, 2018, the old limits, $1,000,000 and $500,000 respectively can be used.
Qualification requirements for a home equity line of credit mostly rely on three factors:
- Sufficient home equity – The ratio of what you owe on your mortgage divided by the market value of your home
- Good credit – A score of 720+ is usually enough to get the best rates, 700-720 can get standard rates and under 700 will receive the highest rates or may get denied
- Sufficient Income – A debt to income ratio of 43% or less is ideal
Advantages
- Fixed and Long draw and repayment periods
- Only interest or minimum payment is required to be paid during draw period
- Can borrow up to 80-85% of home equity
- Only borrow what you need
- Lower interest rates than personal loans or credit cards
- Smaller minimum borrowing amounts compared to other types of lending
- Late payments usually incur a fee, but still must be paid within a set grace period
- Can be used for non home improvement expenses at the expense of its tax deduction
Disadvantages
- Uses variable interest rates which can be unpredictable
- Takes 2-4 weeks to be approved
- Has various setup and transaction fees
- May have annual fee
- Can be suspended if property value decreases
- Need to keep records of home related expenses in case of audit
- Interest only deductible if you itemize deductions
- Missed payments can result in home foreclosure
- Requires credit check and proof of income
- May have minimum withdrawal requirements
Home Equity Loan
A home equity loan is often confused as being the same as a home equity line of credit, but it is a similar yet separate type of loan. Similar to a HELOC, a home equity loan allows you to borrow against the equity in your home, or the market value of your home minus any outstanding mortgages or other loans. Three major differences are that when you apply, you are applying for a fixed amount of money over a fixed period, regardless of the final project cost, the money is paid in a lump sum and usually, the interest rates are fixed. A home equity loan is commonly referred to as a second mortgage because it is structured and operates about the same way.
Another similarity to a HELOC relates to how the interest can be deducted from taxes. A home equity loan follows the same tax laws as a HELOC; the total loans, including the home equity loan on a peropty need to be no higher than $750,000 for joint filers and $375,000 for single filers unless the home was purchased before the tax law went into effect. Also, the funds need to be “used to buy, build, or substantially improve” the home.
There are potentially various fees for a home equity loan
- Application fees
- Upfront charges, like points
- Credit report fees
- Appraisal fees
- Attorney fees
- Title search fees
- Mortgage preparation and filing
- Transaction fees
Advantages
- Fixed interest rate and fixed repayment period
- Can borrow up to 80-85% of home equity
- Receive lump sum all at once
- Up to 30 year repayment terms
- Lower interest rates than personal loans or credit cards
- Smaller minimum borrowing amounts compared to other types of lending
- Late payments usually incur a fee, but still must be paid within a set grace period
- Can be used for non home improvement expenses at the expense of its tax deduction
Disadvantages
- Slightly higher rates than variable rate HELOCs
- May not borrow as much as is needed
- Takes 2-4 weeks to be approved
- Has various setup and transaction fees
- Need to keep records of home related expenses in case of audit
- Interest only deductible if you itemize deductions
- Missed payments can result in home foreclosure
- Requires credit check and proof of income
Other names for a home equity loan are: second mortgage, equity loan, home equity installment loan
Cash Out Refinance
A cash out refinance is another way to access accrued equity in your home. It replaces your existing mortgage with a larger one, or if you own your home outright, is how to obtain a primary mortgage and receiving a lump sum cash payment. When refinancing, most lenders allow up to 80% of the equity of your home to be borrowed against. If you are trying to refinance an existiing mortgage, this means that the maximum amount of cash you can receive will be the difference of 80% of your current home’s value and the outstanding balance of your mortgage. If your home is currently valued at $500,000 and you have $375,000 in mortgage principal remaining, you will be able to receive up to $25,000 (($500,000 x 80%) – $375,000) in cash from the refinance.
A cash our refinance can be a good idea if you need cash and your current mortgage has a higher rate than existing rates. However, if interest rates are higher, it becomes a less attractive option. In the example above, you would receive $25,000 in cash from the refinance, but would be replacing your existing mortgage with $375,000 remaining to pay with a new mortgage of $400,000 and the new interest rate will be on the entire $400,000. If your current interest rate is 4% and the new one is 5%, you will be paying $357 more each month, for the next 30 years ($128,520), to pay off the additional $25,000. If your rate stays the same, your monthly payment increases by $120 and you will pay $43,200 over the next 30 years. If you were to refinance at a lower rate of 3%, your monthly payment would decrease by $104 so you would actually save $37,440 over that same period.
Similar to a mortgage when purchasing your home, you will also incur fees with a cash out refinance. It is typical to pay 3-5% of your new loan amount for the various closing costs. These fees can sometimes be added to your new loan, but you will then be paying interest on the fees for the term of your loan and may even receive a higher interest rate on the entire loan.
There are potentially various fees for a cash out refinance
- Application Fee
- Loan Origination Fees
- Appraisal Fee
- Credit Report
- Tax Service
- Title Insurance
- Government Recording Fees
- Settlement Fee
- Discount Points
Advantages
- Can lower the interest rate on your entire mortgage
- Receive lump sum all at once
- Up to 30 year repayment terms
- Lower interest rates than personal loans or credit cards
- Can borrow up to 80% of the value of your home
- Can use the cash proceeds for any purpose
- Can deduct interest payments from taxes
Disadvantages
- Higher interest rates would be used for your entire mortgage
- Higher fees to obtain than other types of lending
- May not borrow as much as is needed
- Could extend the time it takes to pay off your home
- Interest only deductible if you itemize deductions
- Missed payments can result in home foreclosure
- Requires credit check and proof of income
- More paperwork than other forms of lending
Home Improvement Loan
Home improvement loans can sometimes refer to the general category of various loans available to finance a home improvement project, however, it is most often used as a way to advertise personal loans to people looking to finance a home renovation or repair. A home improvement loan is usually an unsecured loan meaning you do not need to put up any collateral to borrow money like you would with other types of lending options. This means the loan is riskier for the lender and for the borrower, results in higher interest rates, lower loan amounts and shorter borrowing periods. Lenders will commonly let you borrow up to $50,000 with a maximum repayment period of 8 years.
Advantages
- Receive lump sum all at once
- Up to 8 year repayment terms
- Fixed payment terms
- Lower interest rates than credit cards
- Can use the cash proceeds for any purpose
- Potentially no fees for obtaining loan
Disadvantages
- Higher interest rates than other lending options
- May not be able to borrow as much as is needed
- Interest is not tax deductible
- Requires credit check and proof of income
- Medium amount of paperwork
Other names for home improvement loans: personal loan, personal installment loan
Construction Loan
Construction loans originally were created to provide short term financing for people who were looking to build an entire house. They are short term loans, usually under a year, that usually payout funds directly to the builders, for construction costs in stages as the home project gets completed. Today, homeowners are using construction loans for additions and large renovation projects. The lender will usually require detailed plans and timelines for the project along with updates in order to release funds. Once the project is complete, these loans will usually need to be refinanced into your mortgage.
Advantages
- Only need to pay interest during renovation project
- More flexible terms than traditional loans
- An additional party (lender) will be reviewing plans and progress of project
Disadvantages
- Higher interest rates than other lending options
- Requires higher credit score and 20% downpayment
- Need to refinance or pay in full at the end of the project
- Overall costs can end up being higher than expected
- Only get funds as work progresses
- More paperwork
Other names for home construction loans: renovation construction loans, renovation loans, rehab loans
Contractor Financing
Paying for your renovation or home repair through the contractor performing the work is another alternative to other project financing options. This type of loan is similar to getting a loan through a car dealer as they both usually utilize a third party lending source to handle the qualification, origination and ongoing maintenance of the loan. This type of financing may be less common when dealing with an independent contractor who subs out work to other professionals, but for projects such as window installation, roof replacement or solar panel installation, financing from the company performing the work can be more common. If you financed a project through the contractor you hired and don’t like the work they are doing or they stopped showing up to complete the project, you might be unable to easily switch to a different contractor.
Advantages
- It can be more convenient than shopping around for financing yourself
- May offer low or no upfront costs
- May offer similar payment options and terms to bank loans
- May not require any credit check or only requires a soft credit check
Disadvantages
- Usually have higher interest rates than other lending source
- May have additional fees
- Usually through a 3rd party lender
- Missed payments can result in a lien on your property
- Could end up stuck with a contractor you don’t like
Pledged Asset Line
A pledged asset line (PAL) is a product offered by brokerage firms that allows you put up your non-retirement investments as collateral to borrow money. This type of borrowing is setup as a revolving line of credit and is usually an option for high net worth individuals since they are more likely to have a significant portion of their personal wealth invested in assets such as stocks, bonds and other financial instruments. Using a pledged asset line provides cash without having to sell your investments and incur taxes for capital gains. Each month, you are required to make interest payments and the loan remains outstanding indefinitely until fully repaid. The amount you can borrow is usually based upon the risk profile of your assets with U.S. Treasuries offering the highest borrowing percentage and equities offering the lowest. There could also be restrictions for what type of assets can be borrowed against.
Historically, pledged asset lines had been more formal agreements with specified interest rates, borrowing amounts and terms. However, in the last several years, more brokerage firms have been merging the idea of a pledged asset line with margin accounts. Margin accounts have typically been used to allow investors to borrow money from a brokerage firm in order to buy additional assets, but more firms are starting to use these types of accounts to allow the borrower to use the funds outside the brokerage account.
Advantages
- Lower rates compared to other types of loans
- May have a fixed interest rate for a specified period of time
- Provides cash without having to incur capital gains taxes
- Interest can be tax deductible regardless of what cash is used for
- May allow interest payments to be paid from remaining assets in the account
- No fees to setup or cancel a PAL
- Not much paperwork to get setup
- May not require a credit check or proof of income
Disadvantages
- Usually have a variable interest rate with interest charges are less predictable
- Amount you can borrow, as a percentage, is usually less than a HELOC
- You may be required to add funds to your account or pay down borrowed money if the assets in your account decrease in value
- Your brokerage firm could liquidate assets, without notice or input on which securities to sell, to cover a drop in asset value resulting in unwanted tax consequences
- May have a higher minimum initial borrowing amount than wanted
- The terms of a pledged asset line can usually be altered with little notice
- The actual pledged asset line may be through a 3rd party affiliate of your brokerage firm
- Some brokerage firms may suspend dividend payments from collatorized securities or limit account features such as check writing from your account
- You may not be able to switch brokerage firms until borrowed funds are fully repaid
- If opening a PAL through a brokerage firm you don’t have an established relationship with, you could wait 1-4 weeks for assets to transfer from your current broker to the new one and there could be additional delays with the new broker. If opening within your current broker, a separate PAL account may be required which may have limitations such as direct cash withdrawals and no beneficiaries listed on the account.
- Interest is only tax deductible up to the amount of your net investment income and if you itemize deductions (qualified dividends are not included)
A pledged asset line has several advantages over other lending options but they are not without risk. Depending on how much you need to borrow against your assets, your asset allocation and the underlying risk of a drop in the financial markets can quickly make the disvantages outweigh the benefits of a pledged asset line.
Some companies that have been popular for pledged asset lines recently are: Interactive Brokers, Charles Schwab and Wealthfront.
Other names for a pledged asset line are: Portfolio Line of Credit (PLOC), Securities Backed Line of Credit (SBLOC), Securities Based Lending (SBL), Portfolio Line of Credit (PLOC), margin debt, margin loan, margin lending
401k Loan
A 401k loan is a way to access funds in your employer sponsored retirement plan with a requirement to pay the money back within 5 years or potentially longer if the money is used for a purchase of a home. It can be a good way to access funds for a renovation project with lower interest rates than other options and is usually easier to get since you are borrowing from yourself. However, there are some unique aspects of a 401k loan. First, you need to check with your employer if their 401k plan offers the ability to borrow funds from it since not all plans do. Also, the funds available to be borrowed have to be within your current company’s 401k. If you have a 401k from a prior employer that was never rolled over or was rolled into an IRA, then those other funds can’t be borrowed. Lastly, borrowing from your 401k adds another consideration for leaving your employer or could cause additional hardship if you lose your job as the money needs to be repaid once your employment ends.
The biggest disadvantage of borrowing from your retirement account is that the money can’t grow while it’s not in the account which goes against the main purpose of a 401k. Access to 401k funds can be useful in certain situations but borrowing should be closely reviewed to ensure it is truly the best option in the long term.
Advantages
- No application process
- May have lower interest rates than other types of loans
- Can be repaid with payments directly from your paycheck
- Avoid taxes and penalties typically associated with an early withdrawal
- No prepayment penalties
- No credit check
Disadvantages
- Required to pay back money within 5 years with interest
- No guaranteed approval
- Borrowed money can’t grow for retirement
- Maximum loan amount of $50,000 or 50% of your balance, whichever is less
- Funds for borrowing have to be within your current employer’s 401k account
- Must repay the loan in full if you quit, get laid off or fired
- Withdrawn money not protected during bankruptcy
Retirement Accounts
For people who have IRA, Roth IRA other retirement accounts that don’t offer options to borrow from them, funding a renovation could come from withdrawing money directly from the accounts. Similar to a 401k loan, any amounts withdrawn can’t continue to grow but unlike a 401k loan, you are not able to put the funds back into your account unless you do so within 60 days and follow strict IRS rules when doing so. You will also incur a 10% early withdrawal penalty on investment gains in your account unless you can show that the funds are being used for an approved hardship. Any withdrawals of contributions you made to your account are penalty free. Withdrawals made from a standard IRA will also be taxed as income while withdrawals. From a Roth account you can be liable for income tax on withdrawals if the amount exceeds your total contributions. Any amounts withdrawn are first classified as withdrawals from contributions.
Advantages
- No application process
- No interest payments
- Can withdraw contributions with penalties
- IRS allows certain exemptions for penalties
- No credit check
Disadvantages
- No ability to repay withdrawn funds unless paid back within 60 days
- Can owe income tax on withdrawals
- Borrowed money can’t grow for retirement
- Withdrawn money not protected during bankruptcy