When it comes to home improvement projects, even the most frugal homeowners can get caught up in the excitement of choosing finishes and fixtures or get blindsided by an unexpected glitch in their project that increases the cost.
Bob Harkson, chief financial planner at Phase2 Wealth Advisors in Gig Harbor, Wash., recently completed a major kitchen renovation at his home. He says the biggest problem he sees with his financial-planning clients is that they haven’t budgeted enough.
“Every home improvement project will cost more than you think it will and will take more time than you planned,” Harkson said.
Figuring out how much to spend on a home improvement project is tricky, but there are some general guidelines.
“A broad rule of thumb is that you should spend about 5 to 15 percent of your home value on kitchen renovation,” says Dan DiClerico, a smart-home expert for HomeAdvisor, a home improvement platform in New York City. “So, if your home is worth $300,000, you should spend $15,000 to $45,000 on the kitchen. A bathroom renovation should cost about 3 to 7 percent of your home value.”
Sticking to that rule of thumb helps homeowners avoid over-improving their homes for the neighborhood, he says, such as putting in a $100,000 kitchen in a community of $300,000 homes. In general, the more homeowners spend on a home improvement, the less likely they are to see a big return on their investment.
Ballpark figures of how much renovations cost are available from HomeAdvisor’s True Cost Guide and the 2019 Remodeling Cost vs. Value Report. According to the True Cost Guide, the average cost to renovate a kitchen ranges from about $12,000 to $34,000. Those national figures are a starting point. Both reports also offer searchable databases to compare costs by Zip code.
Budgeting for a kitchen renovation can be the most challenging, DiClerico says, because of the many moving parts such as counters, appliances, fixtures, cabinets, lighting and flooring with a broad range of prices.
“The more thorough you are in the planning stages, the more likely you are to come in on budget for your project,” DiClerico says.
Chuck Khiel, vice president of Fred, the home improvement division of Case Design in the District, says he asks customers about how long they plan to stay in their home because that can help them decide between a facelift or a full-blown remodeling project. Replacing a few items in a bathroom will cost less than redesigning it.
“Some people really just want their place to look better, which can be a less expensive cosmetic fix,” Khiel said.
DiClerico says there is no substitute for interviewing multiple contractors.
“Contacting 10 contractors isn’t overkill, at least by phone,” he says. “Then you should meet in person at your home with three to five contractors. That’s the best education you’ll get, and their estimates will show you what renovations cost in your local market.”
Khiel says three things affect the cost of renovation: how much work the homeowners will do themselves, the materials and the complexity of the project.
“If customers can impact any of that, such as doing the painting or demolition themselves or changing the scope of work, that can adjust the price,” he says.
Labor costs vary widely by location, but DiClerico says the average is about one-third of the cost of any renovation.
“If you’re looking to save money on a project, focus on materials, since that’s about two-thirds of the cost,” he says. “Don’t cheap out on labor, because you get what you pay for. Less expensive materials can still give you a good look and good performance. If you lowball your labor costs, you either get sloppy work or unfinished work.”
Many customers save money by purchasing materials online, Khiel says, but this approach has its drawbacks.
“There can be warranty issues,” he says. “We recommend tried-and-true manufacturers, so we know who to call if there’s a problem with a product.”
Before ordering online, have the contractor provide the measurements and specifics. Khiel’s company insists that homeowners who order products themselves be on the site when the materials arrive and inspect everything before accepting delivery.
“When customers are looking for ways to save on their project, we suggest they pick just one ‘whiz-bang’ thing and then choose good quality but less expensive products for everything else,” Khiel says.
DiClerico says it doesn’t hurt to ask a contractor to lower their labor costs, particularly if a homeowner plans to do several home improvement projects in the next few years and would like to establish an ongoing relationship.
After finalizing renovation plans, the next step is figuring out how to pay for it. Sonu Mittal, head of retail mortgage lending for Citizens Bank in Plano, Tex., recommends budgeting 10 percent more than a project’s estimate to account for unforeseen expenses.
Once a homeowner has a sense of how much the renovation will cost, it’s time to evaluate the various sources for funds.
Harkson says the most economical way to pay for a renovation is with reserve funds. This method mostly works for some smaller projects but may not be feasible for homeowners who are doing big projects such as a complete kitchen makeover or an addition.
A Federal Housing Administration (FHA) 203(k) or Fannie Mae HomeStyle Renovation loan can be a good way to finance a renovation because the amount homeowners can borrow is based on the future value of their property after the improvements are made, says Catherine Holtman, operations support manager for Embrace Home Loans in Middletown, R.I.
“An FHA 203(k) loan offers flexibility because you can finance up to 97.75 percent of the improved home value,” Holtman says. “There’s a streamlined version for improvements up to $35,000 that are nonstructural and a standard version for major renovations including structural changes.”
Qualifications for the FHA 203(k) loan are similar to other FHA loans, which allow for lower credit scores and higher debt-to-income ratios than conventional loans. However, homeowners must pay mortgage insurance. This loan program can’t be used for luxury improvements such as a swimming pool.
“With the FHA program and the Fannie Mae HomeStyle loan, your lender will need to approve your contractor’s qualifications, so it’s best to find a contractor familiar with the renovation loan process,” Holtman says.
The HomeStyle Renovation loan requires a minimum 3 percent down payment from a first-time home buyer. Homeowners need 5 percent home equity. Mortgage insurance is required when the loan-to-value is 80 percent or higher.
The ability to finance as much as 95 to 97.75 percent of the improved value of your home makes renovation loans a good option for homeowners without a lot of equity, Holtman says.
Homeowners with enough equity and good credit can opt for a home equity line of credit (HELOC). This can be a good option, particularly if a homeowner plans to do several projects over a few years, Mittal says.
“At first you only pay the interest on the portion of the line of credit you use, and the closing costs are low,” he says.
Most lenders allow homeowners to borrow 80 to 90 percent of their home’s value. This limits the amount a homeowner can finance with a HELOC because it is combined with the first mortgage. On a home valued at $300,000, the maximum limit (90 percent) would be $270,000. If a homeowner’s mortgage debt is $250,000, the HELOC could be no greater than $20,000.
Fees are lower for a HELOC than a refinance, Mittal says, but the interest rates are adjustable and typically a little higher than rates for a first mortgage. Most HELOCs have an initial draw period of five to 10 years when a homeowner pays interest on the balance, followed by a repayment period of 10 to 15 years during which homeowners make fully amortized payments.
When using a HELOC to make home improvements, the interest may be tax deductible. The deduction is not available if the HELOC is used for something other than buying or improving a home.
For homeowners with good credit who need a big chunk of money right away, a cash-out refinance might make more sense than a HELOC, Mittal says.
“You start making payments right away on the whole debt, but it’s extended over 15 or 30 years,” he says. The amount homeowners can finance is typically 80 to 85 percent of the home’s value.
While a refinance has higher closing costs than a HELOC, the interest rates can be fixed or adjustable and are typically lower than a HELOC.
“You need to compare interest rates and think about whether you want to extend your mortgage for a longer period of time,” Harkson says. “You’re also running into danger when you take out money from your home because if the housing market drops you could be upside down on your mortgage.”
A personal loan makes sense if a homeowner is looking to borrow a small amount. There’s less cost involved and it’s paid back over a shorter time than a HELOC or refinance, Mittal says.
Personal loans typically must be repaid in six or seven years, he says, and have a higher interest rate than a HELOC or mortgage.
“Personal loans are better than a credit card because they usually have lower rates,” Harkson says.
If the repairs are necessary and urgent, a 401(k) loan may be worth considering. These loans can offer a lower interest rate. Most 401(k) programs allow a borrower to borrow up to $50,000 or 50 percent of the vested balance. Plus, the interest is paid to the borrower, not a lender.
But there are drawbacks.
“You usually have to repay the loan to yourself with interest within five years,” Harkson says. “The loan comes due immediately if you leave your job, and if you don’t repay it on time, the loan becomes taxable income, plus you’ll pay a 10 percent tax penalty.”
Most financial advisers discourage 401(k) loans.
“Borrowing from your 401(k) should be a last resort,” Mittal says. “You’re jeopardizing your future retirement by taking money from your retirement fund.”
A survey by Houzz found that 1 in 3 homeowners paid for their home renovations with a credit card in 2017. Most of the borrowers took advantage of a no-interest or low-interest promotion. However, in general, credit cards are not a good source of financing because of their high interest rates, Harkson says. The average credit card interest rate was 17.68 percent in April 2019, according to Creditcards.com.
“If you can qualify for a credit card with a low interest rate and have a plan to repay it quickly, then that might be an option,” Harkson says. “But don’t max out the credit card to the limit because that downgrades your credit and will hurt you if you need to apply for other credit.”
Before embarking on a renovation, homeowners should think about their finances and understand how the project will impact their budget.
“If you can only afford to pay another $100 per month, then that should inform how much you spend and whether you choose to pay with a personal loan or a HELOC or something else,” Mittal says.
A home renovation can improve homeowners’ quality of life, but it requires careful planning so the project doesn’t derail their future financial goals.