Many people who apply for a mortgage want to borrow enough money to cover the purchase price of the home they’re buying (minus the down payment they’re able to come up with). But what if the home you’re buying will need improvements? If that’s the case, you may be tempted to take out a higher mortgage.
Here’s how that might work. Say your home costs $200,000. You have $50,000 available for a down payment. So you plan to only borrow $150,000. However, that’s a larger down payment than your lender will ask for. Most lenders are more than satisfied with a 20% down payment. For this example, a 20% down payment would only be $40,000. In this case, you could simply put down less money ($40,000 instead of $50,000), get a larger mortgage ($160,000 instead of $150,000), and use the remaining funds (the extra $10,000 you didn’t use for your down payment) to cover home improvements.
If you already own a home, and you want to start some home improvements, you could take out a larger mortgage. To accomplish this, you’d do a cash-out refinance. When you refinance a mortgage, you swap an existing loan for a new one. Say you have $150,000 left on your mortgage. With a cash-out refinance, you could take out a new loan for $170,000. The first $150,000 would go toward your original mortgage, and the remaining $20,000 would be yours to use for home improvements (or other purposes).
Both of these options will give you access to the money you need to improve your home. But is taking on a larger mortgage a good idea?
Reasons to take out a larger mortgage
Let’s assume you qualify for either a larger mortgage or a cash-out refinance. It could pay to go this route because:
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1. You may be able to borrow affordably
Today’s mortgage rates are extremely low. If you finance your home improvements via a higher mortgage, you could save yourself a fair amount of money. Case in point: On July 7, the average interest rate for a 30-year fixed mortgage was 3.35%. That same day, the average interest rate for a home equity loan was 5.18%.
2. You get a tax break
The interest you pay on your mortgage is deductible if you itemize on your tax return. If you take out a home equity loan or line of credit to pay for home improvements, that interest is deductible as well. But if you decide to stick with a lower mortgage and then finance your home improvements via a personal loan, you won’t be allowed to deduct your interest.
Reasons not to take out a larger mortgage
On the other hand, getting a larger mortgage has its pitfalls:
1. Higher monthly payments
The larger the mortgage you take out, the more money you’ll be on the hook for each month. That’s not a bad thing if you can afford those monthly payments, but if borrowing more means stretching yourself thin financially, you’ll risk losing your home and damaging your credit if your higher payments cause you to fall behind on your loan.
2. You may be tempted to over-improve your home
Money is often a barrier to making home improvements. If you take out a larger mortgage and gain easy access to cash, you’ll be able to renovate as you please. That’s not necessarily a good thing. Many homeowners risk over-improving — sinking so much money into their homes that when they go to sell, they don’t come close to recouping their investment. If you borrow more than you need to cover your home’s purchase price, you may feel compelled to go all out. Doing so may improve your quality of life while you’re living in your home, but it could ultimately be a poor financial decision.
What’s the right call for you?
If you’re able to lock in a truly competitive mortgage rate on an initial home loan or a cash-out refinance, then it could pay to borrow extra to cover home improvements — especially if you’ve mapped out those renovations and understand what they’ll cost. But if those renovations are hypothetical, you haven’t priced them out, and you’re not sure you’ll even want to go through with them, then you may want to hold off on borrowing extra.
Once you take out a higher mortgage, you’re committed to repaying that loan. You’ll start accruing interest on it right away. There’s no sense in taking on that extra expense if you’re wishy-washy on those home improvements to begin with.