What's the best way to pay for your home renovation?

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Taking out a loan against your home equity is a popular way to pay for renovations, consolidate debt or make major purchases.

The best way to tap that equity may vary based on your financial picture and needs. Two of the most common options are a home equity line of credit (HELOC) and a cash-out refinance. While the first approach operates much like a revolving credit card, the second involves an entirely new mortgage on your home.

Here are some of the pros and cons to consider when weighing which option might be right for you.

What is a HELOC & how does it work?

A HELOC is a revolving line of credit offered by lenders based on the equity in your home. Your home’s equity (the difference between its market value and what you owe on your mortgage) serves as collateral.

HELOCs come with a variable interest rate and offer the opportunity to make multiple withdrawals over the contract term.

In other words, if your HELOC credit limit is $50,000 and you use $10,000 for renovations and then pay that money back, you have a total of $50,000 at your disposal once again. The draw period for a HELOC is commonly 10 years. After the draw period ends, you begin repaying any outstanding funds borrowed.

Benefits of a HELOC

There are several upsides when using a HELOC to access money rather than a cash-out refinance, said Matt Hackett, operations manager for Equity Now, a mortgage lender. They have relatively low closing costs and give you the ability to withdraw and pay back money over the draw period.

Another significant point to understand: A HELOC does not replace your existing mortgage.

The drawbacks of a HELOC

Because the interest on a HELOC is variable, the rate can change from month to month, a fact that can be unsettling for borrowers.

HELOCs also typically have a shorter repayment timeline once the draw period ends compared to a cash-out refinance, said Hackett. Typically, HELOCs must be paid back in 20 years, instead of the 30 years commonly associated with mortgages.

“This leads to a higher monthly payment,” said Hackett of the HELOC.

Cash-out refinance

A cash-out refinance is a new mortgage. You’re paying off an existing mortgage with a new one that has different terms, such as a more competitive interest rate.

As part of this process, you receive a lump sum of money that can be spent however you want. In order to obtain the cash-out, there must be equity in your home.

“The cash-out refinance loan is a loan that refinances your first mortgage into a larger mortgage, and allows you to take the difference in cash,” said Michele Hammond, a senior home lending advisor for Chase Bank. “And while you may be able to get cash out from this transaction, you may also be able to shorten your loan term or get a lower rate. That means you may be able to lower your monthly payment or even pay less over the life of your loan.”

In addition, a cash-out refinance can be obtained with a fixed interest rate, which may be more comforting for some borrowers, said Hackett.

One last factor to consider

One of the primary motivations behind refinancing a home is obtaining a lower interest rate and getting lower monthly mortgage payments. (Use our calculator to determine how much house you can afford.)

While this can be appealing, particularly if you have equity and need cash, it’s a good idea to review the overall impact of your choice, said Anna DeSimone, housing finance consultant and author of “Housing Finance 2020.”

“When you refinance, even if the new interest rate is lower, you need to consider what you’ve paid so far. If you've been paying your mortgage for five years, and refinance to a 30-year loan, you’re really making payments for 35 years,” said DeSimone. “The true cost of refinancing is adding up every dollar you’ve paid so far for principal and interest, and add this amount to the entire cost of your next mortgage, including closing costs.”

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