Your House Needs Work. How Should You Pay for It?

America has a home improvement problem. Actually, we have about 145 million of them.

As I keep reporting, the American housing stock is now the oldest it has ever been, with the typical owner-occupied home reaching 42 years old. Nearly half were built before 1980. Which means roofs need replacing, kitchens need updating, mechanical systems are aging—and plenty of houses simply don’t function the way we live today.

Sometimes the project is relatively painless: replace some flooring, remodel a bathroom or finally build that deck.

And sometimes you do what I’m currently doing and remove part of your house, add another bedroom and bathroom, open walls, move mechanical systems and temporarily develop a strangely intimate relationship with your contractor…and your in-laws, where you are temporarily residing (yep, that's me right now). Either way, renovations require something besides patience: money.

Fortunately, there are considerably more ways to finance a home improvement than most homeowners realize. Personal loans, HELOCs, home equity loans, cash-out refinances, renovation loans and even credit cards can all make sense under the right circumstances.

The trick is knowing which tool fits which project—because they are definitely not all created equal. So, if you’re like me and have a project that needs funding—and perhaps a wonderfully low mortgage rate you absolutely do not want to refinance—here are some options to consider.

First, I’d start with the scope of the project, because financing a $10,000 bathroom is very different from financing a $300,000 addition.

The $5,000–$25,000 Project

Perhaps you need new flooring, paint, landscaping, appliances or a modest bathroom refresh. For projects in this range, I’d generally start simple:

• Cash: It’s king. Boring, glorious and zero-interest.
• 0% introductory credit card: Take advantage of a promotional period with little or no interest—but only if you have a realistic plan to pay it off before the promotional rate disappears.
• Personal loan: Simple, fixed payment, fast funding and your house isn’t used as collateral. But convenience isn’t cheap. Depending on your credit and the lender, you could easily be looking at a double-digit interest rate.

The lesson here is pretty simple: don't unnecessarily involve your mortgage in a relatively small project if you have a less expensive way to pay for it.

The $25,000–$100,000 Remodel

Now we’re talking about the projects many homeowners eventually tackle: a substantial kitchen or bath renovation, new windows, HVAC equipment—perhaps it’s finally time for that heat pump—or an outdoor living project, because apparently nothing outdoors is inexpensive anymore.

This is also where financing becomes more important. Meet the HELOC versus the home equity loan.

Okay, so what’s the difference?

• HELOC: A home equity line of credit is a reusable line of credit secured by the equity in your house. Rather than receiving all the money at once, you draw from the line as you need it. Rates are usually variable, meaning your payment can change as interest rates change. As of August 26, the national average HELOC rate was about 7.30%.
• Home equity loan: Instead of a revolving credit line, you receive the money as a lump sum and generally repay it with a fixed interest rate and fixed monthly payment.

A HELOC can be particularly useful during a renovation because construction expenses don't arrive neatly on Day One. You may need $15,000 this month, $30,000 two months later and another $10,000 when someone opens a wall and discovers something horrifying.

HELOC or Home Equity Loan?

The $100,000+ Project

Yep...this is me. Now we’re into additions, gut renovations and substantial transformations. And once the project gets this big, financing becomes considerably more complicated because you may be borrowing six figures while simultaneously trying to protect the financing you already have. For projects at this level, there are a couple of additional tools worth considering.

Construction and Renovation Financing

Many banks offer renovation or construction loans designed specifically for major improvements. Depending on the loan, borrowing capacity may sometimes consider the home's expected post-renovation value rather than simply what the house is worth today.

That's important. If you're putting $300,000 into an addition that materially changes the property, the finished house may be worth considerably more than the house you started with.

My own project is a good example. I'm adding another bedroom, bathroom and actual laundry room, replacing what was previously essentially a stacked laundry closet. That creates value beyond simply adding up the cost of lumber, drywall and plumbing. My house is currently a three-bedroom home. When we're finished, it becomes four bedrooms.

At my home's price point, that's makes a big difference. Luxury buyers generally expect more bedrooms, and there can be a ceiling on value when a larger or more expensive home simply doesn't offer enough of them. In other words, I'm not just making the house bigger. I'm changing the category of house I'm eventually selling.

Cash-Out Refinance

This was an easier decision back when mortgage rates were falling. Today? Maybe not.

Imagine that same $300,000 addition. Now assume someone still owes $400,000 on their house with a 3% mortgage. A cash-out refinance sufficient to cover the project could mean replacing that wonderfully cheap $400,000 loan plus financing the additional $300,000 at today's rates. Oops. You didn't just finance your addition. You also repriced $400,000 of debt that was already incredibly inexpensive.

Instead, keeping the cheap first mortgage and borrowing only the additional money through a HELOC, home equity loan or other second mortgage can be far more appealing. And this deserves a little more attention.

Millions of homeowners—including me—bought or refinanced during the ultra-low-rate years. If you're one of them, your mortgage itself has effectively become an asset. Before considering a cash-out refinance, don't merely ask, "what's the rate on the new money I'm borrowing?" and instead ask, "what happens to the rate on ALL money I already owe?"

Those are two very different calculations. Giving up a 3% mortgage to access renovation money could be considerably more expensive than keeping that first mortgage intact and taking a higher rate only on the additional amount you need.

There's one more potentially valuable consideration. According to the IRS, interest paid on a home equity loan or HELOC may be deductible when the borrowed money is used to buy, build or substantially improve the home securing the loan, subject to mortgage-interest limits and other requirements. So a HELOC used to build an addition and a HELOC used to buy a boat might look identical to the bank. The IRS may see them very differently. Obviously, talk to your accountant before making a financing decision based upon the potential tax deduction. I'm a Realtor—not your CPA!

There isn't one universally "best" home improvement loan. There is only the financing structure that makes the most sense for your project, your equity, your cash flow and the debt you already have.

For a small project, cash or short-term financing may be easiest.

For an evolving remodel, a HELOC gives you flexibility to borrow money as expenses occur.

For a project with a known cost, the predictability of a fixed home equity loan may be attractive.

And for a major renovation or addition, it's worth talking with lenders about construction and renovation financing—especially when the finished project could materially increase the home's value.

But perhaps the most important rule in today's market is this: if you have a ridiculously low first-mortgage rate, think very carefully before giving it up.

Your house may need work. The good news is there's a lot of options to finance it!