The best way to finance a home improvement project is not to do one. That’s because the cost of these jobs almost always outstrips the value they add to the resale price of your home. And if the job is big enough, like doing a major remodel or adding another floor or pool to your home, you will save a ton by selling your home and buying another one that has what you want – no doubt about it.
But if it’s a smaller project, you have no plans to move within the next 5 years and the project would add a lot to your quality of life, it might be worthwhile. The question then becomes, how do you pay for it? As I see it, there are four alternatives:
- Use your cash or sell investments.
- Finance it with the builder.
- Borrow From Yourself.
- Borrow From Others.
It really boils down to using your own money or someone else’s. Let’s consider each option, one at a time, in reverse order:
1. Borrow From Others
Once you get the final cost estimates for the work, add another 20% and go shopping for loans. If payments are a concern, consider refinancing your home and taking some cash out to pay for the home improvement. This option provides you with the lowest monthly payment because it’s stretched out over 15 to 30 years. The issue to watch with a refi is the origination costs and fees.
Many times a refi will cost you 3% to 6% of the principal amount. So if your existing loan is $180,000 and you refi and borrow $200,000 (to free up cash to pay for a $20,000 home improvement) it could cost you $6,000 or more. And paying $6,000 to get $20,000 is crazy expensive.
There are much better ways to borrow from others. These include getting a home equity loan or using a peer-to-peer lending service. While the rates may be higher, the term of the loans are usually much shorter and that means your overall costs are much lower.
For example, let’s say you use one of these short-term loan ideas and you end up paying 3% more per year than you would for the refinance. Further, let’s figure you’ll repay the loan in 3 years.
Now, 3% of $20,000 is $600. So if you pay $600 more interest per year for 3 years, it will cost you $1800 more in interest than the refi would. But it’s a heck of a lot better than that $6000 it costs (minimally) to refinance the house.
Home equity lines and peer-to-peer loans can be less expensive because they have no or low origination fees. But keep in mind that shorter-term loans require higher monthly payments. Make sure you can afford those payments before going down this road.
2. Borrow From Yourself
If you have a retirement plan at work you may be able to take a loan and use that money to finance your home improvement project. Generally, this is a terrible idea. Here’s why.
First of all, you may not have the cash to put back as required. Keep in mind that you must repay this loan in 5 years – or immediately if you lose your job. If you can’t come up with the scratch at that time, you’ll be in a world of IRS pain and penalties.
On the upside, the interest rate is usually low and you pay yourself anyway so that’s all good. Just the same, the risks are very high when it comes to borrowing from your retirement plan. Try to avoid this option at all costs.
3. Borrow From The Builder
Sometimes builders offer financing or can introduce you to people who can finance the work for you. There is no harm in asking what the rates are but they are typically astronomically expensive. If you do talk to a builder or private lender, make sure you understand all the costs associated with the loan, any penalties to pay the loan back early and of course what the interest rate is.
Whatever you do, don’t sign anything when they first present this option to you. The shabbier operators will try to shove you into the contract but don’t fall for it. Just collect the information and have them go away. Don’t sign anything on the spot.
TIP: Contractors love to meet with you at your home. They know that customers won’t throw them out and they can stay and pressure you until the cows come home.
If you want to even things up a little, meet them for coffee at Starbucks rather than at your house. They won’t like the idea and they’ll try to convince you they need to meet you at your home. Don’t fall for it. By meeting in a neutral location you can get up and leave much easier. This alone might pressure the contractor to give you more beneficial terms – and they’ll probably buy you a cup of coffee to boot. Win-win!
4. Use Your Own Money Or Sell Investments
The reason I wanted to discuss this last is because you can only evaluate this option after you have the alternatives mentioned above. Just because you have the cash or money in investments, doesn’t mean you should necessarily use that money to pay for the construction work.
Now that you have information on alternative financing, compare and contrast the costs, terms and risks.
Let’s say you can take a home equity loan for $20,000 and it will cost you 6% a year, you can afford the payments and it will be paid off in 3 years. If you have money laying around earning less than 6%, use it rather than take the loan. And even if you have investments, it may behoove you to liquidate those investments and use this money (as long as it’s not in a retirement account) to pay for the job. Why? Because your investments have risk and the loan doesn’t.
When you use money that would otherwise cost you 6% to borrow, you are saving that 6%. So it’s like earning 6% with no risk. If your investments earn more than 6% with no risk, borrow the money. But if they don’t, you have to think about the risk and make your own decision.
Home improvement jobs can run into serious money and they rarely pay for themselves. That means it’s even more important to be smart when it comes to paying for the work. Get all the information from a variety of financing sources and remember that you can take your time doing so. Once you have all the facts (origination costs, interest rate, pre-payment penalties and risk) make the best decision that fits your situation.
Have you recently done a home improvement project? How did you pay for it? Would you do it the same way if you had to do it all over again? What would you change?