Which Option is Right For You?
Retirement often provides our clients with the time and energy to accomplish the home remodel of their dreams. While you may already have clear visions of your paint colors and new flooring, making decisions around funding these visions may feel a little opaque.
When living on a fixed income, it does not always make sense to pay all cash for a remodel. Often times borrowing money against the equity in your home to accomplish these goals can be a smart financial decision, especially when interest rates are low. If you can obtain a lower interest rate than your expected portfolio returns, it may make sense to leave your funds invested and borrow money at the lower rate. In this article, we will discuss some of the options you have to fund your home improvement goals.
Home Equity Line of Credit (HELOC)
A HELOC is a revolving line of credit that is available for a certain term, called a draw period. Typically, a draw period is about 10 years and during that time you may only be required to pay interest on the amount of money that you have borrowed. After the draw period, you enter into the repayment period (typically 20 years), during which you will make larger payments against your interest and principal. For projects of unknown cost, a HELOC can be a great option. You only pay interest on the money you spend as you go, unlike a traditional loan in which you pay interest on the full amount borrowed starting on day one.
Some disadvantages of a HELOC are that the interest rates associated are typically variable, meaning that they fluctuate with the market. This uncertainty can make it difficult to understand the overall cost of the HELOC up front and to form a repayment plan. However, there may be partial or completely fixed-rate HELOC options available depending on the lender. Additionally, there can often be a large increase from the interest-only payments during the draw-down period to the interest and principal payments that come due during the repayment period.
It is important to understand the fees associated with a HELOC, which could include a fee for not actively drawing on the HELOC. A HELOC is secured by your home, meaning that if you default on your payments, the bank can foreclose or take back the home to satisfy your debts.
Home Equity Loan
A Home Equity Loan is often referred to as a second mortgage. This is because the interest rates and payments are fixed and your home is used as collateral for the loan, similar to a home mortgage. This option is only available if you have significant equity in your home. The amount that you are able to borrow will be dependent upon this equity.
The benefits of a Home Equity Loan are that the interest rates are typically lower than other methods of financing such as personal loans and credit cards, you can pay off the loan early, and you can even refinance this loan. However, the interest rate received on a home equity loan may be slightly higher than what you could receive on your primary mortgage because the home equity loan is second to your primary mortgage (if you still have one), meaning that your primary mortgager would be paid first in the event of a foreclosure.
The disadvantages of a home loan are that a potential downturn in the housing market could cause the equity in your home to decrease, leading the amount you owe on the property to be greater than the value of the home. Additionally, if you default on this type of loan, similar to defaulting on your primary mortgage, the bank may foreclose on the home to satisfy your debt. These are the same risks associated with a regular mortgage.
Other considerations
Under the Tax Cuts and Jobs Act, homeowners who itemize can only deduct interest for home equity loans and HELOCs IF the funds are used to “buy, build, or substantially improve” the property used as equity for the loan. This means that if you use the funds to make substantial home improvements that increase the value of your property, you can still deduct this interest. However, if you use the money to pay for other expenses or if you use your primary residence as collateral to improve your vacation home, the interest will not be deductible.
Cash Out Refinancing
If mortgage interest rates available in the market are lower than your current interest rate, refinancing may be a great option to get cash now and reduce your monthly mortgage payment. Refinancing replaces your old mortgage loan with a completely new one. The lender will pay off your current mortgage and issue you a new mortgage, ideally with a much lower interest rate.
The lower rate will decrease your monthly payment, but a new loan could increase your payment period. For example, if you have a home with a 30-year mortgage, you live in the home for 4 years and then decide to refinance, your new mortgage will be for another 30 years unless you choose otherwise. The further along in your current mortgage you are, more of your payments go to principal. When you refinance, your payments will once again be interest-heavy to start. Understanding the remaining interest you will pay on your current mortgage compared to the interest on the new loan is just as important as knowing what your new payment will be.
Another downside of refinancing is the closing costs. Closing costs can be between 3%-6% of the loan. So if you want to refinance the remaining $300K of your mortgage, the closing costs could be anywhere from $9,000 to $18,000. When considering refinancing, you must consider your break-even point. For example, if you pay closing costs of $5,000 and you save $100 on your monthly payment, it will take you 50 months to break-even and start to recoup your investment. This means that if you are planning to sell your home in less than 50 months, refinancing may not be your best option.
If you are considering any type of refinance, contact one of our financial planners now to put together a loan comparison for you.
When rates are low, there is a lot of competition in the market for lenders hoping to refinance your home. You should absolutely shop around to find the best interest rates and closing costs. Borrowers can often negotiate and find several ways to reduce the costs or wrap them into the new loan.
Other considerations
You typically must have a small amount of equity in your home in order to refinance. Similar to your original mortgage, lenders will look at your credit score, income, net worth, and your debt-to-income ratio when determining if you are eligible to refinance.
Conclusions
Refinancing can be ideal for people who plan to stay in their home long enough to break-even with regard to the closing costs. Home equity loans may be best for borrowers requiring a significant amount of money for a specific project, such as a substantial home improvement. HELOCS are suited to individuals who may be unsure of the amount of money they will need and want access to funds for a long period of time, rather than upfront. Our financial planners can help you evaluate all of your options and decide on the best one for your unique situation.
