The value of your property is no small issue. If you take care of your house and the surrounding grounds, you can up the resale price by tens of thousands of dollars. Replace old trim = increase your home equity.
Because of this reality, people often rush to repair and better their homes without thinking logically about how that financial decision will play out. The prospect of cooking meals in a nicer kitchen combined with the increased property value makes people think a home equity loan or a fresh batch of credit card debt is worth it. I’m here to tell you that type of borrowing is categorically bad.
Since lenders love lending, you have an endless stream of options for taking out money for home repairs. As enticing as some of the borrowing methods might be, they all take you down the same path. Taking on debt to increase the value of your home doesn’t provide the financial boost that some people think it does. Unless you’re selling that house pronto, you’re just going into the red.
I’m going to talk about the five most popular renovation financing options and take shots at all of them. It’s not that I don’t want you to have the house of your dreams; it’s just that I want for you to pay for it responsibly so you can actually enjoy the house of your dreams.
Or as I like to call it, getting some debt to go with your debt.
Refinancing can be a great move. If your mortgage rate isn’t the best and improved credit allows you to improve that APR, I’m all for a quick refinance. And while a cash-out refinance might help you get a better rate, the extra cash you take on top of the existing mortgage makes lowered interest pretty obsolete.
The temptation with a cash-out is to get extra funds without creating a separate loan on top of the mortgage. That way you can pay for home improvements and still keep chipping away at the same monthly fee you’ve been paying. Some people use a cash-out refi with good rates as a means of debt consolidation, which can be an effective tool. However, a new patio is not the same as debt consolidation.
Another smoke-and-mirrors aspect of this financing is the mortgage interest deduction, assuming you can prove the funds went to improving your house. Writing off interest payments feels pretty good around tax time, but you know what feels better? That’s right. Not paying interest.
Here are the main reasons a cash-out refi should be avoided:
● Closing costs
● Renewed debt
Part of the fun of home financing is that you can usually get good rates by using your house as a guarantee. More often than not, this works fine for all parties; you pay your loan off and keep your home, the bank gets its money and doesn’t have to foreclose. Of course, should an unexpected tragedy or medical expense arise, this can go bad in a hurry.
Using property - or anything, for that matter - as collateral is always a good idea until it isn’t. You’ll hear endless success stories from people who put everything on the line and then turned the borrowed money into a small fortune. On the flip side, it’s not too hard to find people who have turned one refinanced mortgage into a second full mortgage, then a third, and the cycle of debt quickly becomes insurmountable. Putting your home on the line in order to finance home renovations opens you up to hardships no one wants to experience.
In addition to the risk, you’ll also have to deal with extra fees. Every refinance comes with closing costs, and a cash-out is no different. If you’ve paid down $100,000 of a $250,000 mortgage and you get a total refi of $200,000, you’ll pay between $5,000 and $10,000 before you’re even out the door. You better have a very classy remodel in mind if you think it’s worth paying 10 large just to get the money you’ll still need to pay back with interest.
Closing costs leave so many people hurting when making the initial home purchase, loading unforeseen bills on top of an already massive expense. To subject yourself to that a second time while diving deeper into debt makes very, very, very little sense. But let’s be honest: when does going further into debt ever make sense?
That’s the real issue here. I never advise people to take on debt for something that’s not a financial asset, and a home doesn’t qualify as an asset. You live in your house, you don’t use it as part of your money-making portfolio. While home equity is undeniably beneficial, you don’t get to think of it as an asset until there’s a for sale sign in the yard. Increased borrowing makes your mortgage last longer, which puts your retirement off further, which makes each day a little less fun. Skip the cash-out refinance, no matter how appealing it looks on its face.
There are two schools of thought here. One, which I subscribe to, is that you would never borrow from your retirement account for anything as that defeats the purpose of the retirement account. The other, which I will entertain for the sake of argument, is that the math works out so borrowing from yourself doesn’t cost you anything in the long run.
If you started an employee-sponsored 401(k) at a young age, stuck with the same company, got vested and somehow avoided the having your account ransacked by brokerage fees, you might feel like you have plenty of money to draw from and that putting those funds into home equity is more of a transfer than a borrow. That ignores the fact that you have to reimburse your retirement account, and that’s harder to do than some people think. If you lose your job or move to another company, you have to reimburse the loan almost immediately or else you’ll face a penalty and tax dues.
Most importantly, growth begets growth in a retirement account. If you don’t take any money out, earnings will lead to more earnings and eventually the dividends and reinvestments will dwarf your contributions. If you take away from the account to add a bedroom or redo the bathroom, that’s not an even trade. Whatever boost you get in equity will not deliver compound earnings. The strength of a retirement account comes from the momentum built as wealth accumulates, and borrowing from those funds undoes years of work.
Unless you can repay your loan amount and make monthly investments, you’ll miss out on any employer matching you had before. Loan payments don’t count as contributions, and employers only match contributions. I’m not a huge fan of 401(k)s to begin with (IRAs are better), but if you have one I definitely want you to keep your money in it, keep getting the contribution from your company, and don’t throw your retirement out of whack for a home improvement project.
These loans are far too popular. Smart people with good jobs and substantial cash flows love HELs and HELOCs because they’re easy to get, the rates are good and the amounts are flexible. You’ll probably put your house up as collateral as you enjoy the fruits of two mortgages, but that’s what a lot of people are into these days.
Frankly, I’d go with either an equity loan or line of credit over a 401(k) loan or a cash-out refi, because you’re throwing away slightly less money. However, a second mortgage isn’t a great thing, and taking on more debt only makes sense for a homeowner who’s about to sell their home. Unfortunately, the temptation with these loans is very strong, because once you have the deed to a house, it becomes very easy to borrow against it. After years of dealing with the horrifying interest rates on credit cards, your home equity loan rate might seem too good to be true.
And, of course, it is. Getting paid a lump sum with a good rate clouds your financial vision. Once the money hits your account, all bets are off, and that’s when the spending starts to outpace the borrowing. And, if you go with the line of credit, you have a different problem to contend with. You might only get charged interest on the amount you withdraw, but the variable rate will make repayment much more volatile.
Above all, I find these particular loans can lead to very bad spending habits. As soon as you start treating your home like a credit card, you inch closer to eventually writing a check that’s going to bounce. Once you’ve moved into your home and set up furniture and hung pictures, it feels like it’s yours forever. A few questionable financial decisions and one unlucky break and you can literally have the rug pulled out from under you.
If a home equity loan helps you make a business investment that will lead to future earnings, that’s a different matter. Strategically borrowed money on a short timetable can prove to be a very useful tactic. However, borrowing against your house to improve your house only puts you in a weaker position when it comes to investing and growing your wealth. Whatever equity you build once the loan is paid off won’t come close to the wealth you could have amassed by investing.
A smaller loan that doesn’t involve your property might feel like the safe choice. In many regards, it is, as you probably won’t lose your house if you have repayment issues, and the smaller amount should theoretically ensure you won’t struggle to reimburse the lender. And yet, a personal loan is the slipperiest of the slippery slopes.
Any time you borrow money for anything, it’s an admission that you can’t afford the thing you want. When we spend money on things we can’t afford, it makes it harder to purchase the things we need in the future. This is why I go on and on about only borrowing money to pay for assets that will increase your wealth, as any other type of borrowing just makes you less wealthy.
If you take out a personal loan for a renovation, the likelihood you’ll pay back that debt is pretty high. As long as you don’t have too many other outstanding balances on the books, I don’t expect one $20,000 loan will drive you into an endless cycle of paying and borrowing. But, I guarantee it will slow your efforts to save and invest. Every cent you pay in interest takes directly from your future self, and it’s foolish to think that any increase in your home’s resale value makes up for that.
You also tend to see higher interest rates on personal loans than HELs and HELOCs. It all depends on the amount you borrow and the terms you get, but people often make the mistake of accepting something crazy like a 25% APR because they plan to pay the loan back quickly. Skip it. Don’t throw your money away. Unless your house is missing a wall and family members are freezing to death, it’s not worth it.
There’s not much more to say on the issue, except to clarify that people who use credit cards to earn rewards and then immediately pay down the balance should continue to go about their business. Another stipulation is for a card that offers a 0% APR grace period, but only if you have a very clear plan for paying off the spending during that window.
Credit card debt consistently ruins lives, tempting people into irresponsible spending and punishing them with predatory interest rates. Do not treat these pieces of plastic like reputable lenders, especially for big expenses that will take a significant amount of time to pay back. Once you get in the habit of living with credit card debt, it becomes exceptionally hard to dig your way out of it. You’ll end up getting a cash-out refi to consolidate your credit cards, then spending more on credit while you use your paycheck to cover the refi cost, and before you know it the bank will own your home. It might sound dramatic but I’ve seen it happen. No. Credit. Cards.
So how do you pay for the renovation you so desperately want? With cash. The same way you pay for your car and your vacations and everything else. If paying for a remodel in cash seems impossible, that’s because you’re too accustomed to living with debt. Once you stop losing money to lenders each month, saving becomes much, much easier, and then you’re just a year or 18 months away from being able to cover the costs of that new bathroom.
It’s good to know about home equity loans and 401(k) borrowing, as you never know when a situation will call for extreme action. Nevertheless, the plan should always be to use the money you have for the non-asset spending you want to do. Stick to this rule and your wealth will go up while your financial anxiety goes way, way down.