To refinance in order to make home improvements you can either take out a home equity loan or an equity line of credit. Both offer pros and cons depending on your specific situation.
A home equity loan usually costs much less than a home equity line of credit (HELOC). With a home equity loan, you are taking out some of the equity in your home in order to fund repairs. With a home equity line of credit, you are borrowing more money which will be tacked on to the overall cost of your mortgage.
Each type of credit will carry with it certain costs. Taking out a first or second mortgage (cash-out refinance / equity line of credit) will increase the overall debt remaining on your mortgage. It can reduce your resale value and throw off your debt-to-income ratio when you sell, making it harder to put down 20% on a new house, thus avoiding paying for Private Mortgage Insurance. An equity line of credit can reduce your monthly mortgage payment and your overall interest rate on your mortgage. It is not an optimal solution unless you intend to remain in your house long enough to repay the loan.
Over the long run, when you take out a HELOC, you will end up paying close to 1% interest on your home improvement loan. The average interest rate on a home is just over 5%. Anything that will push that additional debt up any higher will increase the overall cost of your mortgage and reduce your resale value.
Why Are You Making Improvements?
Next you have to consider why you are making home improvements. If you are doing it in order to fund a major project because you are putting your home up for sale soon, a home equity loan is better over the short term. Often you get that money right back upon resale if you make the right repairs.
What Types of Repairs are You Considering?
Depending on where you live some improvements have a bigger bang for their buck. If you live in the North and Northeast where there is snow and rain, a home equity loan is better used to fund a new roof or plumbing repairs.
If you live on the West coast or in the South, outdoor improvements have the best ROI. Things like a patio or deck, basement renovation, and home theaters have the best ROI. For repairs specifically needed to prepare your home for resale soon, a home equity loan is the better choice.
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